Although a currency board is a common (and simple) way of maintaining a fixed exchange rate, it is not the only way. Countries often keep exchange rates within a narrow band by regulating balance of payments through various capital controls, or though international agreements, among other methods. Thus, a rough peg may be maintained without a currency board.
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 (and all bank creditors of a Reserve Account at the currency board) can convert them into the reserve currency (usually 110–115% of the monetary baseM0).
A currency board maintains absolute, unlimited convertibility between its notes and coins and the currency against which they are pegged (the anchor currency), 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 foreign reserves (less the expense of note-issuing), and does not engage in forward-exchange transactions. These foreign reserves exist (1) because local notes have been issued in exchange, or (2) because commercial banks must, by regulation, deposit a minimum reserve at the Currency Board. (1) generates a seignorage revenue. (2) is the revenue on minimum reserves (revenue of investment activities less cost of minimum reserves remuneration)
A currency board has no discretionary powers to affect 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.
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.
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.
Three cases of a country using or pegging the currency of a neighbor
Hong Kong operates a currency board (Hong Kong Monetary Authority), as does Bulgaria. Estonia had a currency board fixed to the Deutsche Mark from 1992 to 1999, when it switched to fixing to the Euro at par. The peg to the Euro was upheld until January 2011 with Estonia's adoption of the Euro (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.[3] 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. They argue that Argentina's monetary system was an inconsistent mixture of currency board and central banking elements.[4] It is also thought that the misunderstanding of the workings of the system by economists and policymakers contributed to the Argentine government's decision to devalue the peso in January 2002. The economy fell deeper into depression before a recovery began later in the year.
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.
The Faroe Islands have a de jure currency board, but in fact the Danish National Bank serves as the lender of last resort and all bank accounts are denominated in Danish kroner. The Danish National Bank refers to the Faroese króna as a "special version" of the Danish kroner, which is itself partly backed by the Euro foreign reserve of the Danish National Bank.
Estonian kroon, fixed against the Deutsche Mark from independence in 1992 until 1999. Fixed to the Euro thereafter until 2011.
Lithuanian litas, fixed against the US dollar from 1994 until 2002. Fixed to the euro thereafter until 2015 when the litas was replaced with the euro.
Philippine peso fixed to the 'milled dollar' during the Spanish and American colonial era, up until 1941. Pegged to the Japanese yen from 1942 to 1944. Post-independence, it was also pegged to the United States dollar from 1946 to 1959, and again from 1966 to 1983.
De la Torre, Augusto & Levy Yeyati, Eduardo & Schmukler, Sergio L., 2003. "Living and dying with hard pegs: the rise and fall of Argentina's currency board," Policy Research Working Paper Series 2980, The World Bank.
Tiwari, Rajnish (2003): Post-Crisis Exchange Rate Regimes in Southeast Asia: An Empirical Survey of De-Facto Policies, Seminar Paper, University of Hamburg. (PDF)
"On Currency Boards: An Updated Bibliography of Scholarly Writings." ()
Steve H. Hanke and Kurt Schuler, Currency Boards for Developing Countries: A Handbook (1994, revised edition 2015).
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, pp.203–222. (PDF)
Arnaldo Mauri, The Currency Board and the rise of banking in British East Africa, W.P. n. 10–2007, Department of Economics, University of Milan. Abstract in English.
Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise, Currency Board Book Series, Studies in Applied Economics working paper series (includes many papers on currency boards),, and Digital Archive on Currency Boards.
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