Currency board

Short Definition

A currency board is a monetary authority which is required to maintain an exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.

Features of "orthodox" Currency Boards

The main qualities of an orthodox currency board are:

• A currency board's foreign currency reserves must be sufficient to ensure that all holders of its notes and coins can convert them into the reserve currency (usually 110–115%).
• A currency board maintains absolute, unlimited convertibility between its notes and coins and the currency against which they are pegged, at a fixed rate of exchange, with no restrictions on current-account or capital-account transactions.
• A currency board only earns profit from interest on reserves (less the expense of note-issuing), and does not engage in forward-exchange transactions.
• A currency board has no discretionary powers to effect monetary policy and does not lend to the government. Governments cannot print money, and can only tax or borrow to meet their spending commitments.
• A currency board does not act as a lender of last resort to commercial banks, and does not regulate reserve requirements.
• A currency board does not attempt to manipulate interest rates by establishing a discount rate like a central bank. The peg with the foreign currency tends to keep interest rates and inflation very closely aligned to those in the country against whose currency the peg is fixed.

Consequences of adopting a fixed exchange rate as prime target

The currency board in question will no longer issue fiat money but instead will only issue one unit of local currency for each unit (or decided amount) of foreign currency it has in its vault (often a hard currency such as the U.S. Dollar or the Euro). The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank.

Pros and cons of a Currency Board

The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners. Typically, currency boards have advantages for small, open economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

Examples of Currency boards in recent history

Hong Kong operates a currency board, as do Bulgaria and Lithuania. Estonia established a currency board pegged to the Deutsche Mark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. To some, this emphasised the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. However, Argentina's system was not an orthodox currency board, as it did not strictly follow currency board rules - a fact which many see as the true cause of its collapse.

The British Overseas Territories of Gibraltar, the Falkland Islands and St. Helena continue to operate currency boards, backing their locally printed currency notes with pound sterling reserves.

A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.

Countries with a currency board against the Euro

• Bulgarian lev
• Estonian kroon
• Bosnian mark (Konvertibilna marka)
• Lithuanian litas
  • For an updated list of currencies pegged against the Euro, see Currencies related to the euro

Countries with a currency board against the US Dollar

• Hong Kong dollar
• Saudi riyal

Countries that have historically had a currency board

• Irish Punt, pegged against Sterling from independence until 1979.

Literature

• Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg. (PDF)

For a precise definition of what constitutes a currency board, including past examples, see:

• Hanke, Steve H. (2002): On Dollarization and Currency Boards: Error and Deception, Journal of Policy Reform Vol. 5 no. 4, pp203-222. (PDF)

Italic text== See also ==

• Central bank
• Monetary policy
• Argentine Currency Board

External links

• Currency boards and dollarization