Everything about Currency Board totally explained
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 (and all banks creditor of a Reserve Account at the currency board) can convert them into the reserve currency (usually 110–115% of the monetary base M0).
- A currency board maintains absolute, unlimited convertibility between its notes and coins and the currency against which they're 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 interests on foreign reserves (less the expense of note-issuing), and doesn't 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 effect monetary policy and doesn't lend to the government. Governments can't print money, and can only tax or borrow to meet their spending commitments.
- A currency board doesn't act as a lender of last resort to commercial banks, and doesn't regulate reserve requirements.
- A currency board doesn't 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 wasn't an orthodox currency board, as it didn't 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.
Examples of currencies with a currency board against the euro
Bulgarian lev
Estonian kroon
Bosnian mark (Konvertibilna marka)
Lithuanian litas
Examples of currencies with a currency board against the U.S. dollar
Hong Kong dollar
Bermudian dollar
Cayman Islands dollar
Djiboutian franc
East Caribbean dollar (Antigua and Barbuda, Dominica, Grenada, Saint Kitts and Nevis, Saint Lucia, and Saint Vincent and the Grenadines)
Examples of currencies with a currency board against the pound sterling
Falkland Islands pound
Gibraltar pound
Saint Helena pound
Examples of currencies with a currency boards against other currencies
Brunei dollar, against the Singapore dollar
Macanese pataca, against the Hong Kong dollar
The Faeroe 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 krone.
Examples of currencies that have historically had a currency board
Irish pound, pegged against pound sterling from independence until 1979.Further Information
Get more info on 'Currency Board'.
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