nga Elton Dusha

1. Some background

The Banjska attack emphasized and brought to light the Serbian government’s use of its financial and military assets to destabilize northern Kosovo and create a parallel structure of institutions that challenges the Republic of Kosovo’s domain in the area, both political and economic. One way in which the Serbian government does this is through an up-to-now unregulated system of dinar denominated cash flows into Northern Kosovo, under the alleged aim of paying pensions to its citizens there. Unaccounted for cash flows can finance a number of illegal activities, but, even if all activities were above board, the fact that a lot of these transactions are cash based and not traceable by any Kosovar central authority creates problems for both monetary and fiscal policy. It creates problems for fiscal policy because a lot of this cash in dinars may not be declared as income and therefore not taxed, and it creates problems for monetary policy because, if transactions in Northern Kosovo are not performed in Euros, monetary policy instruments may be less effective.

In order to remedy the situation, the response of the Republic of Kosovo has been multidimensional. It no longer allows cash shipments from Serbia, a prudent decision, as every nation retains the authority to intercept cash believed to be supporting illicit activities from entering its borders. However, here I will concentrate on a very specific measure, the regulation of the Central Bank of Kosovo (CBK) relating to the use of non-euro currencies (Shqip, English). Article 36, Chapter VI states: (emphasis mine)

Other non-euro currencies can be used in the Republic of Kosovo only as a store of value in physical form or in bank accounts in non-euro currencies, for making international payments in non-euro currencies and for foreign exchange activities.

 The CBK is essentially stating that the dinar (or any other non-euro currency) cannot be exchanged for goods and services in the RK, even if two private parties agree to do so. The measure has been somewhat controversial. The following will be an attempt at some clarification.

2. What is legal tender anyway?

In most western countries, legal tender often establishes the currency to be used for settling debts and paying taxes. That essentially implies that, if you owe someone a debt, they have to accept the sovereign currency[1] as a means of payment and that the government only accepts payment of taxes in legal tender. This seems to be the common theme of legal tender across countries. One notable exception is the US, where the dollar is only the suggested means of payment. However, the US is not a good example since the dollar is such a dominant currency that it makes the US case an extreme outlier. In other countries, legal tender often means that taxes must be paid using sovereign currency and that, if someone wishes to settle a debt using legal tender, the payee cannot refuse. Here is the EU for example on the latter feature of the legal tender concept, here is the Bank of Canada on the same concept.

In some countries, such as Switzerland, the currency must be accepted as means of payment if offered, while in others, such as the UK and Canada, this is not the case. So in Switzerland, if someone walks into your store and wants to buy using CHF, you have to accept them, while in the UK, you can refuse to accept payment in pounds.

In most countries however, transacting in any currency other than legal tender is not explicitly prohibited. The above links state this unequivocally, but here is a member of the ECB’s executive board making the same point. To sum up, while in some countries one must accept the sovereign currency as means of payment and in some others this is not the case; in most countries (with the exclusion of, perhaps, totalitarian regimes), the use of other currencies in transactions is not explicitly prohibited. So if I walk into a store in most of the world and I want to use a currency other than the country’s legal tender, if the shop keep is willing to accept it, the transaction is not illegal.

3. Wait what? How does this work?

So how do countries then make sure there is a demand for their legal tender when private parties can use any currency? Basically this is left to market forces[2]. Transaction costs make it difficult to use other currencies as means of payment. If you want to pay your local butcher using shekels in Canada, he is unlikely to accept because it would be costly (in time and fees) to convert shekels into Canadian dollars. There is also the problem fluctuating exchange rates, if they are volatile, the butcher is receiving a risky means of payment. So to avoid these costs, most people settle their accounts using the national currency, or, if they accept other currencies, they charge prohibitive premiums that force buyers to carry local currency. But the use of legal tender is not enforced through exclusivity.

Without getting too into the weeds of monetary theory, money has this odd feature that if someone expects that most other people will accept some currency, they themselves will also accept it as a means of payment. So the use of a currency is generally predicated on expectations; if you think most people will accept a currency, you will also do so[3]. You can see this in border areas, shops will accept both currencies because someone will eventually pass by who will actually require service in either, which makes holding the foreign currency nearly costless. So if both currencies provide the same liquidity services, i.e. they can be exchanged for goods and services quickly and with low to no cost, both will be held. As transaction costs diminish, people may use non-legal tender currencies for daily transactions. For example, a lot of shops and restaurants in Albania will accept Euros. This is because opening an account in Euros in Albania is fairly easy and many others will accept the Euro for payment for other goods and services, so transaction costs are smaller. But note that the use of Euros for payment in Albania is not illegal, if both parties agree to it.

4. Ok, what does this mean for Kosovo?

The CBK is trying to perform something economists call currency substitution, the process of substituting the use of a foreign currency for the local one. In countries that have episodes of very high inflation due to currency mismanagement, citizens regularly abandon the local currency because it is no longer a good store of value. This often means that monetary policy has less of a bite, so countries try, either through the force of law or by using incentives, to steer citizens towards the use the domestic currency[4]. Kosovo’s situation is very unique, it might be the only country in the world that does not issue its own currency and where inflation is not really a problem, that is trying to discourage the use of another currency for reasons unrelated to inflation. Nonetheless, one can learn from the international experience on how to do currency substitution.

One thing I learned looking at the literature is that outright bans are not common. Argentina, Zimbabwe, Venezuela and a few of other countries have done so, mostly because episodes of hyperinflation have pushed citizens of those countries towards the dollar. This is because bans are inefficient and difficult to enforce. It often creates black markets in foreign currencies and pushes the intended target of the ban underground, making it even more difficult to enforce. Kosovo finds itself in the unenviable position of trying to use a limited arsenal of monetary and fiscal policy tools to combat Serbian intransigence, and needs to look for the most efficient ones to do so.

There are a few possible ways out of the current situation that could achieve the intended effect without relying on an outright ban. I will highlight some of them here, but I am sure I am missing others that would be just as useful. This is an early and incomplete attempt to explore other methods that use incentives rather than bans.

• Kosovo can discourage the use of the dinar by offering higher rates on euro accounts. If euro deposits earn more than dinar deposits, most people will move towards euro accounts and holding dinars will become more expensive. This should change the relative price of dinars and make transactions in dinars less desirable.
• The CBK can require higher reserves to be held by private banks if they hold deposits in dinars. Fundamentally this would make holding dinars more expensive for private banks, in effect offering lower rates on those accounts and indirectly discouraging the holding of dinars. This measure is related to the one above, as it uses rates to encourage holding euros instead of dinars.
• Fiscal policy can also help by imposing higher taxes on transactions performed in dinars. There is a possibility here that, in order to circumvent this, businesses may record transactions held in dinars as transactions performed in euros. This will hinge on the exchange rate and the premium that businesses may charge for using dinars given the above two measures. If the premium of using dinars is high enough, evasion should be less frequent.

All these measures are meant to increase the transaction costs of doing business in dinars and, in so doing, incentivize the use of Euros. There are drawbacks to these policies, after all, there is no free lunch, but if well implemented, good policy should be able to lower their costs. There are ways to discourage the use of dinars that are much more effective than an outright ban, measures that would be significantly less controversial and attract minimal, if any, negative attention.

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[1] I will use sovereign currency and legal tender interchangeably.
[2] Central Banks often intervene in foreign currency markets to manipulate exchange rates and affect non legal tender usage.
[3] A lot of this expectation depends on the demand for local currency established by law for tax payment.
[4] It is not clear that currency substitution is even desirable in this case. The link above makes the point that foreign currencies may serve as a disciplining mechanism for wayward central banks.