Issue is trade is only a small component of balancing international payments. UAE has no capital controls, so anyone can swap Dirham for Dollar freely, and their Central Bank must defend the rate they set. It’s basically a money laundering haven so…
I would expand the third point is even more complicated and it’s not just independent monetary policy but also independent fiscal policy you have to give up. At the extreme, no matter how high the interest rate is, a peg cannot be defended without running out of reserves. Basically you cannot:
Provide absolute promise to provide a fixed rate for converting local currency to another. (fixed exchange rates)
Provide convertibility in unlimited amounts. (no capital controls)
Unconstrained (Gov spending and bank credit creation) creation of domestic money convertible into foreign currency i.e. demand to convert domestic money into foreign currency does not exceed the system’s capacity.
All at once. UAE does so because its reserves are so large attacking the peg is very difficult and usually impractical but mechanically the peg is theoretically breakable, even currency boards like Hong Kong are (they only back base money, not all money). So credibility matters a lot.
Base money includes some of the Government liabilities like bank notes, coins, settlement balances (also known as reserves which are balances held by commercial banks at Central Bank used to settle payments between banks). It does not include Government bonds.
More importantly, it doesn’t include bank loans. Commercial banks create money too, they use leverage to create bank loans in excess of liquid assets they have which creates bank deposits (bank money). This is called endogenous money. And this bank money is special in that it is ‘money’, Government accepts it to settle debts you owe to it (eg. taxes, fees, fines), contracts are also largely enforced in bank money (you cannot buy a house with cash in many countries for instance, you can with bank money).
Another thing, bank money is also freely convertible to base money at par ($1 of bank money = $1 of base money). The Central Bank makes sure that’s the case so there are no run on banks, when you make a transfer from one bank to another, base money is used (aforementioned settlement balances), you also convert bank money to Government’s by withdrawing cash (since that’s a Govt liability). If there is a system wide shortage of settlement balances, the Central Bank must provide it else risk payments system failing at the extreme.
Given that bank money is freely convertible to base money, that bank money is created well in excess of base money (due to leverage), and that the base money is convertible without capital controls to USD (for example), the ‘currency board’ cannot guarantee convertibility to US Dollars in a mechanical sense. The usual claim that currency boards cannot be broken isn’t true.
Raising interest rates is a way to keep people from exchanging base money for foreign currency, acts as a sort of an incentive. This cannot work in the extreme, e.g. Russia in the 90s where Central Bank raised rates to triple digits, paying out billions in Rubles which were convertible to US Dollars.
Of course, this doesn’t apply if your currency floats, in this case any intervention becomes discretionary.
Issue is trade is only a small component of balancing international payments. UAE has no capital controls, so anyone can swap Dirham for Dollar freely, and their Central Bank must defend the rate they set. It’s basically a money laundering haven so…
See
I would expand the third point is even more complicated and it’s not just independent monetary policy but also independent fiscal policy you have to give up. At the extreme, no matter how high the interest rate is, a peg cannot be defended without running out of reserves. Basically you cannot:
All at once. UAE does so because its reserves are so large attacking the peg is very difficult and usually impractical but mechanically the peg is theoretically breakable, even currency boards like Hong Kong are (they only back base money, not all money). So credibility matters a lot.
Could you please unpack this? What is base money?
Base money includes some of the Government liabilities like bank notes, coins, settlement balances (also known as reserves which are balances held by commercial banks at Central Bank used to settle payments between banks). It does not include Government bonds.
More importantly, it doesn’t include bank loans. Commercial banks create money too, they use leverage to create bank loans in excess of liquid assets they have which creates bank deposits (bank money). This is called endogenous money. And this bank money is special in that it is ‘money’, Government accepts it to settle debts you owe to it (eg. taxes, fees, fines), contracts are also largely enforced in bank money (you cannot buy a house with cash in many countries for instance, you can with bank money).
Another thing, bank money is also freely convertible to base money at par ($1 of bank money = $1 of base money). The Central Bank makes sure that’s the case so there are no run on banks, when you make a transfer from one bank to another, base money is used (aforementioned settlement balances), you also convert bank money to Government’s by withdrawing cash (since that’s a Govt liability). If there is a system wide shortage of settlement balances, the Central Bank must provide it else risk payments system failing at the extreme.
Given that bank money is freely convertible to base money, that bank money is created well in excess of base money (due to leverage), and that the base money is convertible without capital controls to USD (for example), the ‘currency board’ cannot guarantee convertibility to US Dollars in a mechanical sense. The usual claim that currency boards cannot be broken isn’t true.
Raising interest rates is a way to keep people from exchanging base money for foreign currency, acts as a sort of an incentive. This cannot work in the extreme, e.g. Russia in the 90s where Central Bank raised rates to triple digits, paying out billions in Rubles which were convertible to US Dollars.
Of course, this doesn’t apply if your currency floats, in this case any intervention becomes discretionary.