(Title image: financialtrading.com)

Is it possible to have a Welsh currency, with the relative security of the pound? Yes, it is.

Introduction

A fixed exchange rate system (also known as a pegged exchange rate) is when one currency’s value is fixed against the value of another currency. It’s common practice amongst smaller countries who want to have an element of monetary independence, also want predictability on currency values but don’t want to “float” their currency (Part VI) and leave them at risk of things like higher inflation or big changes in the exchange rate.

From 1927-1979 the Irish punt was fixed 1:1 with the pound sterling, meaning 1 punt was worth 1 pound. This was done, essentially, to prevent any significant barriers to trade developing after the partition of Ireland and it (sort of) worked – Ireland maintained a significant trading relationship with the UK for decades and Ireland’s trade with the UK accounted for as much as half of Irish imports and exports for several years after it joined the (then called) EEC.

However, once the Republic of Ireland decided to join the European Economic Mechanism (EEM) – a pan-European fixed exchange rate as a precursor to the euro (Part IV) – they broke the link with sterling and largely benefited from it, though it didn’t entirely meet expectations (more from the former head of the Irish Central Bank, Prof. Patrick Honohan – pdf).

Pegging doesn’t necessarily mean a Welsh currency needs to have 1:1 value with another currency; it could be set lower or even higher depending on precisely what our goals are. If we want to export more to the nation to which we peg our currency, for example, it might make sense to fix the value lower (i.e. 1 Welsh pound = £0.80p/$1.03/€0.94).

The Requirements

A Welsh Currency (physically) – Wales would need a distinct currency of our own, with our own bank notes, coins etc. All bank deposits in Wales and prices in Welsh stores would have to be converted on whatever day the new currency comes into use. We would also need the means by which to produce bank notes (and a contract with, presumably, the Royal Mint to produce coins).

A Welsh Central Bank – Sounds simple enough, but would have a number of complications. The governance structure would need to be outlined well beforehand, and we would have to decide whether it should be independent of the Welsh Government (like the Bank of England) or, in effect, an extension of the Welsh Treasury (meaning the Welsh Finance Minister would set things like interest rates). In addition, bank notes and coins would be honoured in the name of the Welsh Central Bank/Welsh Government rather than the Bank of England

Choosing a currency to peg to – There are three realistic options:

  1. Pound sterling – We know what to expect when using it so it would presumably be the front-runner, with an aim to have a 1:1 exchange rate. The Isle of Man and Gibraltar have separate currencies pegged 1:1 with the pound. As mentioned earlier, the Republic of Ireland also had a currency pegged to the pound between 1927-1979.
  2. US dollar – The most commonly pegged currency in the world. Around 60 countries peg their own currencies to the dollar. It acts as the world’s reserve currency and is particularly popular amongst countries that do a lot of exporting to the United States. The USA is one on Wales’ main trading partners, but the EU and the rest of the UK outstrip it.
  3. Euro – A popular choice in Europe. Around 20 countries are pegged to the euro, particularly former French colonies in Africa, non-eurozone EU members like Denmark and prospective future EU member states like Bosnia-Herzegovina. It wouldn’t be a bad option if Wales maintains high levels of trade with the EU post-Brexit.

The pound would probably be the best choice due to cross-border trade and “familiarity”.

More complicated options – Wales wouldn’t have to peg to a single currency, or even have a fixed exchange rate while pegged to a currency. For the sake of simplicity, it would be worth only pegging to one currency, but there are other options including:

  1. A crawling peg – A system which allows the value of a pegged currency to rise up or down (usually down) by a fixed amount in response to market conditions (i.e. changes in interest rates). Only two countries – Botswana and Nicaragua – use a crawling peg.
  2. A peg band – This is similar to a crawling peg except for the upper and lower limits for how much the value of the pegged currency can change are fixed. The euro’s ERM II system (Part IV) is an example of a pegged band.
  3. Basket of currencies – This is where a currency is pegged to the average value of multiple currencies (a basket). This is particularly useful when a country has multiple important trading partners, so in Wales’ case it would presumably be an average of the pound, euro and US dollar
  4. Currency board – Instead of having a Central Bank, the value of the currency is set in law to be pegged to the value of a foreign currency. The government would lose the ability to print its own money and there would be no lender of last resort. It’s usually an option in developing countries.

At-a-Glance Assessment

  1. Autonomy – Wales would have greater autonomy than in a formal currency union and some monetary policy areas would be the responsibility of the Welsh Government and Welsh Central Bank. However, maintaining the exchange rate with pegged currency would need to be a monetary policy priority partly reliant on the economic policies of a foreign government or central bank, and we would have to match interest rates. We would have the option of being able to break the link and become a floating currency (Part VI) when needs be.
  2. Convertibility – If Wales tried to maintain a 1:1 value with a pegged currency then our currency would be converted on the same basis.
  3. Credibility – As long as we were pegged to a credible currency (particularly on a 1:1 basis), it should be enough to convince investors, businesses and the public that a Welsh currency is a safe option. It works in the Isle of Man well enough and there’s no reason why it couldn’t work here either.
  4. Stability – Pegging is more stable than introducing a floating currency. As we wouldn’t have a formal currency union there would be no issues around asymmetry and Wales would be able to have a significant element of fiscal independence – but it would all have to be within reason and maintaining a fixed exchange rate would force fiscal discipline on the Welsh Government.
  5. Foreign trade – This depends on which currency we peg to. If we peg to the pound then we would probably be able to do a lot of trade with England; if we peg to the euro the same thing could be said of the EU etc. However, exports usually benefit from weak currencies and it would be difficult to have a weaker currency than whatever nation/currency we peg to, particularly if we want to maintain 1:1 value.
  6. Identity – Wales would have its own bank notes and coins as a separate Welsh currency would be a pre-requisite.
  7. Mobility – If we maintained a fixed 1:1 value with another currency then exchange with that currency shouldn’t be a problem, but if we set our exchange rate lower then people would have to convert currencies before entering or leaving Wales which would be inconvenient but could also help retain more money from Wales within the Welsh economy.
  8. Synchronicity of economic cycles – Unlike a formal currency union, Wales wouldn’t have to align fiscal policy with another country and our own central bank would act as a lender of last resort. However, this would mean having to introduce with our own deposit guarantee schemes and financial regulations etc.

Key Advantages

Predictable exchange and inflation rates – This is particularly useful for exporting nations (like Wales) and they can rely on exchange rates staying roughly where they are, keeping the price of exports artificially low and remaining competitive on the global market. Because of these levels of certainty, inflation can also be kept down or at least very similar to the home nation of the currency we’ve pegged to.

Imposes discipline on a Welsh Central Bank – We would effectively be “outsourcing” many aspects of monetary policy and this would not only provide stability to a newly-independent country but also force the Welsh Government and Welsh Central Bank into not taking aggressive or radical monetary policy shifts. Interest rates and financial regulations, for example, would need to be similar to the pegged nation. While a Welsh Central Bank would need to become a lender of last resort within Wales, the government would need to be prudent when it came to budget deficits, quantitative easing and government borrowing to maintain the exchange rate.

Maintains current investment and trade flows – It would be a lot easier to do trade with the nation/group of nations to whom we’ve pegged our currency because the monetary policies will need to be similar. If Wales pegged our currency to the pound, there’s the chance the pound sterling would continue to be accepted as currency in Wales, which would help maintain reserves; though that wouldn’t necessarily be the case vice-versa in England (as happened with the Irish punt when it was pegged – the pound was accepted in Ireland, but the punt wasn’t accepted in the UK).

Key Disadvantages

Increases foreign influence – Monetary policy would, effectively, be indirectly determined by whatever nation/group of nations we peg currencies with. For example, if we pegged a Welsh currency to the pound and the Bank of England increased interest rates to combat inflation there, then the Welsh currency would be in trouble (think Black Wednesday) and English influence over the Welsh economy would increase. This is a particular problem if Wales has a trade deficit with the nation to which we’re pegged, and we wouldn’t be able to use a floating currency to re-balance.

A Welsh Central Bank would require large foreign currency reserves – In order to maintain a fixed exchange rate, a central bank needs to constantly buy or sell domestic and foreign currencies and be able to exchange a fixed amount of the local currency for a fixed amount of the pegged foreign currency. We would be due to receive a proportional share (4.9%) of the UK’s currency reserves, worth ~$7.39billion (£5.63billion) in June 2017. It’s unclear whether this would be enough as it would depend on prevailing economic conditions, but it’s likely to be. It’s a disadvantage because maintaining this exchange rate would be a competing priority with other monetary policy issues.

Breaking a peg can cause massive currency fluctuations – Wales wouldn’t be locked into a fixed exchange rate and, as said earlier, we would be able to break the peg at any time. However, when that happens the value of the Welsh currency will need to be determined by a market rate and this could cause serious short-term instability that may catch out investors, businesses and consumers and lead to Wales falling prey to currency speculators.

Conclusion

A Welsh currency pegged to the pound sterling has one of the best mixes of autonomy, stability, identity and convertibility – but it’s not perfect. It’s a great way to ensure stability immediately post-independence, but it still means – despite the money itself looking different – tying our monetary policy to someone else.

Pegging 1:1 value with the pound would be the sensible option initially, but once the post-independence economy has stabilised – and if the Welsh Government wants to maintain exports as a priority – it would be a prudent move to devalue the Welsh currency slightly compared to the pound (i.e. 1 Welsh pound = £0.90p) or even breaking the link altogether and becoming a floating currency. That’s what I turn to next.

Part VI looks at a floating Welsh currency.