Currency Board

A currency board is a monetary arrangement in which the authority issuing a country's notes and coins may do so only against an equal or greater amount of a foreign "anchor" currency, and is legally committed to exchange its currency for that anchor at a fixed rate on demand. It is the strictest form of currency peg short of abolishing the national currency altogether.

By tying the domestic money supply to its stock of foreign exchange reserves, a currency board gives up independent monetary policy. In exchange it gains credibility: the public can see that each unit of local money is backed and can be converted, which makes the peg hard to break and inflation hard to create.

An orthodox currency board follows a small set of rules:

• Full backing. The monetary base, meaning notes, coins and often bank reserves, is backed at least 100% by reserves in the anchor currency, usually held as safe foreign assets.
• Fixed rate written into law. The exchange rate is set by statute rather than by policy decision, so changing it requires legislation.
• Automatic money supply. Local money is created only when someone sells anchor currency to the board, and destroyed when someone buys it back. Interest rates therefore follow the anchor country's rates plus a risk premium.
• No lending to the government. The board cannot buy government debt, ruling out monetary financing of deficits.

Because it cannot create money freely, a pure currency board has little ability to act as lender of last resort to banks. Some modern boards keep a limited buffer of excess reserves for that purpose.

Currency boards originated in the British Empire in the nineteenth century as a way to give colonies a local currency backed by sterling without a central bank. Large regional boards followed in the twentieth century, including the West African Currency Board and the East African Currency Board. Most were replaced by central banks after independence.

The model revived in the 1980s and 1990s. Hong Kong introduced its Linked Exchange Rate System in 1983, fixing the Hong Kong dollar at 7.80 to the US dollar; the Hong Kong Monetary Authority now operates it within a narrow convertibility band. Estonia (1992), Lithuania (1994), Bulgaria (1997) and Bosnia and Herzegovina (1997) adopted boards after periods of high inflation or transition; Estonia and Lithuania later joined the euro. The Eastern Caribbean Central Bank runs a quasi-currency board for its member states, and the Bulgarian National Bank operated one anchored first to the Deutsche Mark and then to the euro.

Supporters argue that currency boards end high inflation quickly, impose fiscal discipline and lower borrowing costs by removing devaluation risk. They are most often adopted after hyperinflation or political upheaval, when trust in a discretionary central bank is low.

Critics point to the trade-offs described by the impossible trinity: with a fixed rate and open capital flows, the country must accept the anchor's interest rates even when they do not suit the domestic economy. Adjustment to shocks must then come through wages, prices and employment. Argentina's convertibility plan of 1991, which tied the peso one to one to the US dollar under currency-board-like rules, ended in 2002 amid recession, bank deposit freezes and default, after a strong dollar and weak exports left the economy uncompetitive. Argentina's system was not an orthodox board, but the episode is the most cited warning about rigid pegs.

A conventional fixed peg leaves the central bank discretion to change the rate, to sterilize reserve flows and to lend to banks; a currency board removes most of that discretion. Full dollarization goes further by abandoning the local currency entirely, eliminating even the residual risk that the board's law is repealed. At the other end of the spectrum, a floating exchange rate lets the market set the price of the currency. Monetary unions such as the CFA franc zones share some features with currency boards, including a fixed parity to the euro, but operate through common central banks. The board's discipline also echoes the gold standard, with a reserve currency taking the place of gold.