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A blog on financial markets and their regulation
Since the prophets of gloom and doom are now talking openly of a possible breakup of the euro zone, I thought it would be useful to look back at some instances of breakup of currencies to see what really happens. I have chosen some examples based on my familiarity with them and describe them below in reverse chronological order. I think the examples are fascinating in their own right regardless of what one thinks about the prospects of the euro zone
Many analysts have drawn parallels between the current Greek crisis and the Argentine crisis of 2001. Therefore, my first example is the Argentine pesification of 2002. The process began in December 2001 with the corralito which froze all bank accounts for 12 months while allowing withdrawals of $250 a week for essential expenses. This led to riots that forced the resignation of the president. During the next two weeks, Argentina went through three interim presidents while also defaulting on its debt. In January 2002, interim president Duhalde announced an asymmetric pesification in which dollar denominated bank deposits were converted to pesos at 1.40 peso to the dollar while dollar denominated loans given by the banks were converted at 1.00 peso to the dollar. The government issued compensation bonds to the banks for the differential of 0.40 pesos, but at that time, the government was widely regarded as insolvent. The free market exchange rate was approximately 4 pesos to the dollar. The Argentine Supreme Court declared the corralito and the pesification unconstitutional. The government responded by impeaching two judges and forcing the resignation of two others. In October 2004, the Supreme Court ruled that pesification was legal. A good chronology of most of these developments can be found in Gutierrez and Montes-Negret (“Argentina’s Banking System: Restoring Financial Viability”, produced by the World Bank Office for Argentina, Chile, Paraguay and Uruguay, 2004).
Another example with similarities to the euro zone is the breakup of the ruble zone in the early 1990s after the collapse of the Soviet Union. While the overthrow of Gorbachev and the fall of the Soviet Union were political in nature, the breakup of the ruble zone was primarily due to economic reasons. After the collapse of the USSR, no change in monetary arrangements were made – the newly formed Central Bank of Russia (CBR) took over the old Soviet central bank (Gosbank) in Russia while Gosbank branches in the other countries became 14 independent central banks. However, all the printing presses were in Russia and so only the CBR printed rubles. The other countries relied on ruble notes and coins shipped from Russia by the CBR.
The old soviet system was based on a dual monetary circuit: enterprises could convert rubles in the bank (beznalichnye or non-cash rubles) into cash (nalichnye) only for specified purposes – chiefly the payment of wages, which were paid in cash. All inter-enterprise transactions were required to be in non cash (beznalichnye) rubles to facilitate central planning and control (see for example, William Tompson, 1997, “Old Habits Die Hard: Fiscal Imperatives, State Regulation and the Role of Russia’s Banks”, Europe-Asia Studies, 49(7), 1159-1185). This dual circuit continued in the post soviet ruble zone as well. The implication was that while the CBR had monopoly on cash rubles (nalichnye), other central banks could and did create non cash (beznalichnye) rubles.
Initially, the CBR continued the old soviet practice of accepting beznalichnye rubles of other ruble zone countries as payment for exports from Russia to these countries. So the central bank of Ukraine could lend beznalichnye rubles to a local bank which could lend them to a local factory which could use these to buy inputs from Russia. Effectively, Ukraine was paying for this stuff with rubles created by itself. This has striking similarities to how Germany has been lending to the rest of the euro zone through the ECB’s Target2 system.
At some point, the CBR decided that it would not accept beznalichnye rubles of other central banks. It also began printing new Russian rubles for use within Russia while printing old soviet rubles for shipping to other ruble zone countries. Finally, in 1993, the CBR unilaterally demonetized soviet era ruble notes and exchanged them for Russian rubles. The ruble zone was effectively terminated and the remaining 9 ruble zone countries (some countries had left even earlier) were forced to adopt their own currencies. Ultimately, the ruble zone broke up because Russia (or more precisely CBR) was not prepared to pay the economic price required for its continuation. A good discussion of the collapse of the ruble zone can be found in Abdelal’s paper (“Contested currency: Russia’s rouble in domestic and international politics”, Journal of Communist Studies and Transition Politics, 2003.)
My next two examples are closer home from the Indian subcontinent. In early 1971, Bangladesh declared independence from Pakistan, but the government-in-exile could return to the country and start functioning only nine months later. During this war of independence, Bangladesh continued to use the Pakistani currency without any change. Many people dealt with this incongruity by rubber stamping “Bangladesh” or “Joy Bangla” on these notes in English or Bengali. Images of these notes can be seen here and here.
Pakistan however took the stance that the war of independence was a civil war and that the notes circulating in Bangladesh were looted from the branches of the Pakistan central bank (State Bank of Pakistan) in East Pakistan (Bangladesh). It then declared that all note carrying the inscription “Bangladesh” or “Joy Bangla” or “Dacca” in any language would not be legal tender in Pakistan. It also proceeded to issue new currency notes in different colours and withdraw the old notes from circulation. (These events are described at the web site of the State Bank of Pakistan). This demonetization resulted in the paradoxical situation where the old Pakistan currency notes now circulated only in Bangladesh which was at war with Pakistan!
Even after winning the war of independence, Bangladesh retained the old currency for several months. The statute setting up the Bank of Bangladesh stated that “all Bank Notes, Coins and Currency Notes … which were in circulation in Bangladesh [on December 16, 1971] shall continue to be legal tender”. Subsequently, Bangladesh printed new currency and exchanged the old notes.
The other example from the subcontinent was the partition of undivided British India into India and Pakistan in August 1947. The two countries agreed that the Reserve Bank of India (RBI) would act as the central bank of Pakistan also for over a year (till September 1948). During this period, the government of India agreed to take two nominees of the Pakistan Government on the central board of the RBI. During this transition period, Indian notes were to remain legal tender in Pakistan, and the RBI was to issue notes overprinted with the inscription ‘Government of Pakistan’ in English and Urdu. During the transition period, these overprinted notes were to be the liability of the RBI, but not of the Government of India.
At the end of the transition period, the Government of Pakistan was to exchange the (non overprinted) Indian notes circulating in Pakistan at par and return them to India. The overprinted notes would become the liabilities of Pakistan. The division of assets of the Issue Department of RBI was to take place after the transition period. The division was to be based on the ratio of notes circulating in the two countries at the end of the transition period.
When the Kashmir dispute erupted later, the financial settlement between India and Pakistan broke down, and the RBI’s role as the central bank of Pakistan was terminated three months ahead of time. An excellent account of all these events can be found in Chapter 18 of Volume 1 of the RBI History. Images of Indian rupees overprinted with ‘Government of Pakistan’ in English and Urdu can be found here.
I now move back from the Indian subcontinent to Europe for my final example – the breakup of the Austro Hungarian Empire in 1919. Richard Roberts (“A stable currency in search of a stable Empire? The Austro-Hungarian experience of monetary union”, History and Policy Paper 127, October 2011) provides an excellent discussion of this episode and its relevance for the euro zone. After the defeat of the Austrian Habsburg Empire at the hands of Prussia in 1866, Hungary threatened secession from the empire. The Compromise of 1867 was a constitutional treaty that recognised the sovereign autonomy of Austria and Hungary under a single monarch – the Austro-Hungarian Dual Monarchy. The two parts of the empire had separate parliaments and separate national debt, but there was a monetary union under the Austro Hungarian Bank (AHB). Like the European Central Bank (ECB) today, the AHB established a strong reputation for a policy of sound money. For a long period, the AHB was also able to rein in the fiscal profligacy which had been the hallmark of the Austrian Habsburg Empire.
Everything changed with the First World War. After its defeat in this war, the Austro-Hungarian Empire collapsed into five successor states – Czechoslovakia, Romania, Yugoslavia, Austria and Hungary. The peace treaties specified that the successor states should stamp Austro-Hungarian Bank notes circulating in their areas and then introduce their own notes. Successor state claims on the reserves and other assets of the Austro-Hungarian Bank was in proportion to the notes circulating in their territories. Stamping was done by affixing adhesive stamps or by rubber or metal stamps. Images of these stamped notes can be seen in the delightful paper by Keller and Sandrock (“The Significance of Stamps Used on Bank Notes”) and also at Wikipedia.
Stamping of notes to turn them into legal tender was a form of taxation and in some countries the tax rate was excessive. This created incentives for people to forge the stamps especially when the stamping was lacking in security features. The value of the stamped currency depended on the monetary policy followed in the various countries. This created incentives for unstamped AHB notes to be smuggled out of profligate countries for stamping in countries with more sound money. Reducing these substantial illicit cross-border flows required customs check points and deployment of army patrols.
The interesting thing about this episode was that out of the five successor states of the empire, only one (Czechoslovakia) was able to create a central bank with anything resembling the sound money attributes of the old AHB. Hungary for example went on to have one of the worst hyperinflations in world history.