Along with the problems of unemployment and fiscal debt, the world’s currencies have been plunged into turmoil.
The Swiss franc, the currency of a country that has a few things in common with the Cayman Islands, shot up from $1.082 (USD/CHF) on 5 April of this year to $1.375 on 10 August, an increase of 27 per cent in four months.
The franc’s appreciation relative to the Euro over the same period was about the same.
An American buying a Swiss watch suddenly found it that much more expensive and an Eastern European company that had borrowed in Swiss franc, and there were many that did, suddenly owed that much more in Euro.
On 6 September, the Swiss National Bank announced that: “The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development [and that it] is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.”
What are the implications or lessons for Cayman and its currency from Switzerland’s experience and the general exchange rate instability of recent years?
The CI dollar is fixed to the US dollar for two reasons. The first is that by issuing (and redeeming) its currency at a fixed exchange rate for another currency the Cayman Islands Monetary Authority establishes a clear, creditable and market driven rule for how much of its currency to issue. Its currency board rules are simple, reliable and time tested. No one ever questions its value and the ability to exchange it for US dollars.
As part of CIMA’s currency board regime, it adheres carefully to the reserve management guidelines developed by the International Monetary Fund. The US dollars it receives when issuing its currency are invested so as to achieve safety first, liquidity second and income only third. Thus the CI dollar’s reserve backing is invested in US dollar assets backed by the full faith and credit of the US government with relatively short maturities.
The second reason for fixing the CI dollar to the US dollar is that most of Cayman’s trade (including tourism) is with the US or other countries pegged to the dollar. Thus fixing to the dollar minimises fluctuations in prices of imports and exports that might originate in changes in the exchange rate.
Put differently, CIMA has chosen a fixed exchange rate monetary policy for very sound reasons. Among the many currencies (or things – such as gold) CIMA could fix its currency to, the US dollar provides the greatest stability because the value of the dollar in the US has been reasonably stable (low inflation) for some time and because much of Cayman’s trade is with the US.
But no system is perfect. Cayman also trades with non-dollar areas as well. Over the past ten years, for example, the USD/EURO rate has varied from 0.86 to 1.57, almost 100 per cent, which departed widely from fundamentals and poses serious challenges for Cayman and international trade more generally. When the USD depreciates relative to the Euro, so does the KYD; and British and European tourists find Cayman more affordable and Caymanians find European imports more expensive.
In a world in which the major currencies fluctuate against each other, world trade suffers. Relative prices from one part of the world go up and later may go down again. Trade patterns shift to follow the best prices. These adjustments can be costly and painful. There is no escaping it in a world without one global currency.
This year’s French led G20 discussions are focusing on the reform of the international monetary system in the search for how to mitigate this problem. One set of proposals would promote the IMF’s Special Drawing Rights (SDRs) as a supplement to the USD as an important international reserve currency. I discussed some of these ideas in an earlier CFR: “Do We Need A New Global Currency?”, Cayman Financial Review, Issue 18 First Quarter, 2010.
The SDR is currently valued on the basis of a basket of the world’s four major currencies (the USD, Euro, UK pound and Japanese yen). When the current basket was established on 1 January of this year these currencies had the following weights in the basket: US dollar 41.9 per cent, Euro 37.4 per cent, Pound sterling 11.3 per cent and Japanese yen 9.4 per cent. These weights vary slightly from day to day as exchange rates change.
Fixing the CI dollar to the SDR rather than to the USD might more closely match the actual financial dealings and trade of the Cayman Islands with the rest of the world. It would not eliminate relative price changes of imports from Europe and the US when the USD/EURO rate changes but it would soften them. CIMA might consider whether fixing to the SDR rather than the USD would be desirable. While almost 90 per cent of Cayman’s imports come from the US, a larger share of its export (tourist visitors and financial services) may go elsewhere (unfortunately Cayman’s Economic and Statistics Office does not report the geographical breakdown of such exports).
CIMA could also construct its own currency basket to more exactly match Cayman’s global trade. However, fixing to an internationally established basket has the advantages of greater simplicity, wider use and recognition, and the possibility that a growing number of countries will also fix to the SDR thus fixing their exchange rates relative to the KYD.
Cayman’s monetary regime has served the Cayman Islands very well. It is not broken and does not need to be fixed. But it is worth considering whether fixing its currency to a mix of USD and Euros (ie SDRs) would make life on the Islands a bit easier. It is not obvious, however, that such a change would be an improvement.
Two additional, less dramatic reforms would lower the cost of using CI dollars in Cayman and should also be considered. The first concerns the cost to the public of buying and selling CI dollars for USD. The second concerns making payments in CI dollars via deposit transfers.
CIMA generally issues and redeems its currency through the local retail banks rather than directly with the public. It deals with banks at CI$ = US$1.20 without a buy/sell spread. However, it will sell directly to the public at CI$ = US$1.227 (a buy/sell spread of 4.5 per cent).
The rates at which banks sell and redeem CI dollars with the public basically reflects the spread used by CIMA, which is very wide by foreign exchange dealing standards. This spread could be significantly reduced without keeping banks from profiting from providing this service. Generally a narrower spread would be applied to deposit than to cash transactions.
When bank customers make payments via deposit transfers (by issuing cheques), payments drawn on deposits in one bank and deposited in another are cleared daily in Cayman by the local banks and settled in accounts maintained by these banks in a New York bank in USD.
This increases the cost of a normal payment within the Cayman Islands using cheques. If CIMA allowed banks to open CI$ clearing accounts with CIMA, such payments could be made quicker and more cheaply by transfers between bank balances with CIMA in CI$. Such deposits would be fully backed with USD assets in the same way as CIMA’s currency liabilities.
Even without these refinements, Cayman’s currency has serviced its people well.