Money and Markets: Essays in Honor of Leland B. Yeager

158 Maria Minniti and Lidija Polutnikof lending, and may slow down the development of domestic markets. In addition,the possibility of some unexpected depreciation could lead to further flight from thecurrency. Although moderate in recent years, currency substitution could thenbecome an inflation pass-through. Policy options such as the adoption of the euroas the official currency or the imposition of more strict limits for the dirty floatcurrently applied have all been discussed (Vujic and Wachtel 2003). Nevertheless,unlike Slovenia, Croatia remains vulnerable to the possibility of a new inflationaryspiral.The stabilization period and the virtuous circleA crucial aspect for the introduction of the new currency and, in general, for thesuccess of the stabilization process was the central bank’s choice of an appropriateexchange rate. Several arrangements were possible with respect to the foreignexchange system. Among them was the use of a currency board in which the tolarwould be linked to the Deutschemark through a fixed conversion rate and the issueof tolars would be fully backed by foreign exchange reserves. 18 The currency boardwas ruled out because Slovenia did not have foreign exchange reserves and externalfinancial support could not be secured to allow this arrangement to succeed. 19 Analternative proposal contemplated the introduction of a parallel currency tocirculate alongside the Yugoslav dinar. Under this arrangement, both currencieswould have remained legal tenders. This proposal was strongly opposed from thebeginning because the existence of the new currency alongside the old dinar wouldhave reduced the perception of complete autonomy from the old regime andweakened popular support. This, in turn, would only aggravate the existingcurrency substitution problem while, at the same time, leaving Slovenia exposed toYugoslav inflation and monetary attacks.Although the pegging option, favored by foreign experts, was debated for a fewmonths, the newly created central bank, and the political leadership headed byPrime Minister Lojze Peterle, both stood firmly in favor of a single independentcurrency, of a floating exchange system, and of monetary rigor. Their position,eventually, prevailed. 20 Initially, the Deutschemark was used as the reference currency,and the starting exchange rate for assets and liabilities in foreign currencieswas set to be 32 tolars per Deutschemark. 21 The initial tolar exchange rate was setrather arbitrarily to match the real exchange rate of the dinar. From October 1991to June 1992, the external value of the tolar declined sharply. The depreciation hadseveral causes. First, the new central bank had not yet built its reputation. Second,while popular expectations about the new currency were very optimistic, there wasstill some currency substitution. Third, inflation, although decreasing, was stillsignificant. Throughout 1992 the Bank of Slovenia maintained its commitmentto domestic stability. Thus, monetary policy was aimed at regulating the moneysupply, while the exchange rate was determined endogeneously. 22By April 1992, six months after the creation of the central bank, and less than ayear after independence, the creation of a new independent monetary area and theintroduction of a new stable fiat currency both had been successfully accomplished.