Unification of the CUP and the CUC, through the revaluation of the CUP and elimination of the CUC, is necessary to restore the functions of money in the Cuban economy, but not sufficient. The new currency will need to serve as a unit of account, store of value and measure of value not only within the domestic economy, but also for international trade. For this, it will need to be convertible, and if so, its value needs to both reflect supply and demand, and be sufficiently stable to earn the confidence of trade partners. What system would meet those requirements in the case of Cuba?
Alternative systems: float, fixed peg, sliding peg, managed peg
Free float
In theory, a new currency needs to be allowed to float freely in order to find its market level. However, this would be impractical for Cuba, where structural reforms are likely to lead to dislocations and in which financial markets are still very underdeveloped. Under these conditions, currency volatility would damage economic activity and trade.
Adoption of a foreign currency
At the other extreme, absolute currency stability could be achieved by replacing the Cuban currency with a foreign currency. The adoption of a foreign currency is useful as a currency anchor when that currency dominates a country’s international trade. Until now, the Convertible peso has been pegged to the US dollar (the natural choice given that Cuba’s main traded products – sugar, nickel and oil – are denominated in US dollars in the international market), but adoption of that currency is ruled out by US sanctions. These not only prohibit Cuba from using US dollars for international trade, but also punish its trading partners if they engage in dollar transactions with Cuba. If the dollar is not a possibility, no other currency would seem to be a feasible candidate, as none of Cuba’s other trading currencies account for more than half of its international transactions.
Sliding peg
Another alternative is a sliding peg against a foreign currency, which allows the authorities the ability to adjust the new currency for differences in inflation between Cuba and the country of the currency in question. However, determining what is, actually, the rate of inflation in Cuba would be challenging given that many prices are fixed by the government at levels that are way out of line with what would prevail in a market-based economy. A sliding peg that is based on a basket of currencies would have the additional challenge that Cuba's structure of trade, which has changed enormously over the past two decades, is likely to continue to do so in the coming years.
Fixed peg
By deduction, then, the logical solution appears to be a fixed currency peg, to anchor its value. The new currency could be pegged against the US dollar as the Hong Kong dollar has been since 1983. Alternatively, it could be pegged against the euro. Another option is the offshore traded Chinese renminbi (CNH), which is used extensively in Hong Kong.
Many of the best-known and successful currency pegs in the world today are used by governments of territories that are generally (if not always entirely correctly) seen as bastions of free enterprise. Hong Kong is a good example. Closer to Cuba geographically, so too are the Cayman Islands and Bermuda.
However, the mechanism is transferable to other types of economy. In the case of Singapore, a modified currency peg has been adopted by a one-party state, with a ruling People's Action Party (PAP) that has emphasised an independent national identity since independence in 1965, and intervenes heavily in the economy. There, the peg has contributed usefully to very strong economic performance with the gains very widely (if not totally evenly) spread across the population.
Steve Hanke and Kurt Schuler, two well-known academic proponents of the currency peg, advocated the mechanism’s adoption by Cuba's government in 1992, arguing that this would be necessary to ensure that money serves as a medium of exchange, a store of value and as a meaningful unit of account.
They identified two aspects of currency pegs that would be important considerations for the Cuban authorities should they choose to peg the peso to another country. First, currency pegs need to be run by currency boards which are different in concept to central banks, in that they do not run monetary policy, act as lender of last resort, provide banking services to the government or (necessarily) act as institution of note issue. For Cuba, the creation of a currency board to administer a new revalued and convertible Cuban peso, pegged (in their case, they suggested that the peg should be to the US dollar) would be relatively straightforward. The Central Bank would carry out other central banking functions, but would not hold the foreign currency reserves that underpin the peso, or be able to expand or reduce credit in the economy.
The second essential aspect of a currency peg would be more of a challenge: the need for it to be credible. For this to happen, the currency board should be a strong and independent institution with a clear and narrow mandate and, above all, it must maintain sufficient reserve assets to buy back the local currency that it issues.
(i) Creating a credible fixed peg: institutional requirements
Hanke and Schuler noted that one measure to boost the credibility of the currency board as a strong and independent institution might be the appointment of suitably qualified foreign nationals to its board. Their vision was of a currency board to be set up under the supervision of the US authorities in the wake of the collapse of the Cuban communism. The expectations of the early 1990s of the imminent collapse of the Cuban government have been shown to have been misplaced, leaving the question of whether or not it might be possible to create a credible, strong and independent currency board under the current system.
Even after Raúl Castro has left office (which will be no later than 2018), the Cuban government would be unlikely to countenance an intrusion into national affairs such as that proposed by Hanke and Schuler, but the authorities have demonstrated a willingness to accept technical assistance from foreign experts. It is therefore possible that the Central Bank, if it were to adopt a currency peg system, would allow foreign officials with experience of existing currency pegs (for example from the Hong Kong Monetary Authority, the Monetary Authority of Singapore and/or Banco Central do Brasil a central bank with long experience of exchange rate management) to play some role in providing advice and auditing of a currency board, if this was considered to be necessary to ensure its credibility.
(ii) Creating a credible fixed peg: reserve assets requirements
The greatest challenge for the Cuban currency board in terms of establishing a credible currency peg would be to obtain the reserve assets sufficient to match the money supply. The UN’s Economic Commission for Latin America and the Caribbean (ECLAC) estimates that, at current prices, Cuba's GDP in 2011 amounted to US$68.2bn, and Mesa-Lago and Pérez-López (2013) note that monetary liquidity (M2) varied between 37% and 47% of GDP in 2005-11. Therefore if the authorities seek, in the first instance, to achieve a Cuban peso money supply of around 30% of GDP, they would need international reserves of around US$20bn.
It is impossible to know the current level of Cuba’s foreign exchange reserves. The Cuban Central Bank does not publish any information on the level of reserves, on the grounds that they are national security-sensitive. For a few years, from 1993 to 2001, it published information on annual changes in their level, but since then even that information has been classified.
Balance of payments accounts provide some clues, but the rest is guesswork. The current account has been close to balance since 2001, with an average deficit of less than 1% of GDP. No figures have been provided for the capital account, but with major infrastructure and energy sector investments (financed from Venezuela, Brazil and China) having brought in substantial net new financing, it is likely that net capital inflows have been greater than the net current-account deficit, suggesting that the level of international reserves has probably been rising. On the basis of the available data, a very rough estimate of Cuba's foreign reserves would be around US$5bn. This would imply that the currency board would need to find an additional US$15bn or so.
To raise this amount, the currency board would need to persuade international creditors to purchase Cuban bonds. This would be challenging. For Cuba, US sanctions are the main problem here: they not only block access to US banks but also to multilateral financial institutions, and deter others. The currency board would have to seek the support of unorthodox creditors such as the governments of China, Russia, and Venezuela plus, possibly, the governments of Brazil, Ecuador and Angola. It could also offer the bonds to any private sector investors that do not have US interests that might be threatened. These might include, for example, mainland Chinese financial institutions with subsidiaries operating in Hong Kong.
A further problem for Cuba is its poor debt history, with defaults in 1986 and again in the early 1990s, a breakdown in negotiations with Paris Club creditors in 2001, and a unilateral temporary suspension of repayments again in 2008-9 (following a devastating hurricane season). Mesa-Lago and Pérez López suggest that, in 2010, Cuba's total foreign debt could have been as high as US$72bn (including US$28bn owed to Russia, US$16bn to Venezuela and US$9bn to China), although other estimates suggest that the total (including ‘inactive’ debt that has not been serviced since 1986), is nearer US$25bn. Although the Cuban authorities are now prioritising debt repayments and the economic reform process appears to be steady and rational, potential investors would need much reassurance.
The currency board would need to persuade potential purchasers of its bonds of Cuba’s potential for investment and growth that would arise from the stability and full convertibility of the new CUF. As argued above, the long term prospects for the Cuban economy would be improved by the unification of the exchange rate. Stable money would result in higher productivity and greater dynamism in both state enterprises and the non-state sector, enabling the government to repay outstanding debts and improving creditworthiness. But with a poor track record and creditor unfamiliarity with Cuban conditions and prospects, it would be difficult to reassure creditors.
It might therefore be worth considering the possibilities for offering creditors some security against state assets. Individual Cuban state enterprises are accustomed to offering claims on future revenue streams as security, but a national bond issue would be a different question. There is a precedent, in the issuance of €400m of one-year bonds by the Central Bank in 2005-06, which were then listed on the London Stock Exchange in April 2006. The interest rate was 7%. The listing was designed to improve Cuba’s access to international financial markets, but it was not new debt: it merely consolidated existing obligations to domestic state banks and foreign banks operating in Cuba. The issuance of bonds to raise new money on this scale would therefore be a new departure for Cuba.
If the Cuban government wished, it could also create a state holding company with ownership of a bundle of profit-making state enterprises – perhaps along the lines of Singapore’s Temasek Holdings. The Cuban government could then give foreign holders of Cuban bonds long-dated warrants over a small share (perhaps 10-20%) of the new holding company. The warrants held by foreign investors would be detachable from the bonds and would be tradable. Given the likely involvement of Chinese investors and the success of the currency peg in Hong Kong, the Hong Kong Exchange (HKEx) might be one place for Cuban warrants to be listed, but it is not the only one. Changes in the value of the warrants over time would provide insights as to how developments within Cuba's economy are perceived in the wider world. The establishment of the CUF as a stable and convertible currency would of itself be consistent with a rise in the value of all state enterprises in Cuba.
Warrants over some of the shares in the new holding company could be allocated to Cuba’s citizens. This should give them a sense of stakeholding. Further, the citizens’ warrant holdings might be used as a foundation for a new social security (and/or social engineering) mechanism along the lines of Singapore’s Central Provident Fund. However, this aspect of the Singaporean model would be unlikely to be of interest to the Cuban government, at least in the current stage of the reform process. At present, it sees no need to develop such a funding mechanism to persuade Cubans that they are stakeholders in the economy and reform process; this purpose is supposed to be fulfilled by the universal guarantee of basic needs and free health and education, the national consultation that set the guidelines for reform, and the on-going systems of participation and review that are a feature of the Cuban approach to restructuring.
