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INTRODUCTIONTO CURRENCY BOARDS

Kurt Schuler 

This is a summary of what currency boards are and where they have existed. Read this even if you think youknow about currency boards; chances are you will learn something new. The information here was current asof June 2002.

Central banks and currency boards

In most countries today, the monetary authority--the organization that issues the currency--is a central bank.A typical central bank today is a wholly government-owned body, separate from the ministry of finance, thathas a monopoly of issuing notes (paper money) and coins. A typical central bank today has a high degree of discretionary power: it is constrained by no monetary rule, such as a binding commitment to a particularexchange rate or inflation rate.

Only a few countries, mainly in Europe, had central banks before the twentieth century. Central banking didnot became widespread in the Americas until the period between the First and Second World Wars, and didnot become widespread in Africa and Asia until after the Second World War. Until then, countries that nowhave central banks had a variety of other monetary systems, which generally provided more monetarystability than central banks have done.

Among the other monetary systems that once were widespread were currency boards. Unlike the rest of theother monetary systems, which have all but vanished, currency boards have enjoyed a revival of interest sinceabout 1990. A few countries have established currency board-like systems, and others have debated whetherto have currency boards.

What a currency board is

A currency board is a monetary authority that issues notes and coins convertible into a foreign anchorcurrency or commodity (also called the reserve currency) at a truly fixed rate and on demand. An orthodoxcurrency board typically does not accept deposits. A currency board can operate in place of a central bank or

as a parallel issuer alongside an existing central bank; cases of parallel issue have been quite rare, though.

As reserves, a currency board holds low-risk, interest-bearing bonds and other assets denominated in theanchor currency. A currency board's reserves are equal to 100 percent or slightly more of its notes and coinsin circulation, as set by law. A currency board generates profits (seigniorage) from the difference between theinterest earned on its reserve assets and the expense of maintaining its liabilities--its notes and coins incirculation. It remits to the government all profits beyond what it needs to cover its expenses and to maintainits reserves at the level set by law. An orthodox currency board has no discretion in monetary policy; marketforces alone determine the money supply.

Characteristics of a currency board

The main characteristics of a currency board are as follows.

Anchor currency: The anchor currency is a currency chosen for its expected stability and internationalacceptability. For most currency boards the British pound or the U.S. dollar has been the anchor currency,though for some of the recent currency board-like systems the anchor currency is the euro. The anchorcurrency need not be issued by a central bank; a few currency boards have used gold as the anchor currency.

Convertibility: A currency board maintains full, unlimited convertibility between its notes and coins andthe anchor currency at a fixed rate of exchange. Though an orthodox currency board typically does notconvert local deposits denominated in its currency into the anchor currency, banks will offer to do so for asmall fee.

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A currency board has no responsibility for ensuring that bank deposits are convertible into currency boardnotes. That is solely the responsibility of banks. The currency board concerns itself only with the notes andcoins that it issues.

Unlimited convertibility into the anchor currency means that in an orthodox currency board system, norestrictions exist on current-account transactions (buying and selling goods and services) or capital-accounttransactions (buying and selling financial assets, such as foreign bonds).

Reserves: A currency board's reserves are adequate to ensure that all holders of its notes and coins canconvert them into the reserve currency or commodity. Currency boards often hold reserves of 105 or 110percent of their liabilities, rather than just 100 percent, to have a margin of protection should the bonds theyhold lose value.

Profits: Unlike bonds or most bank deposits, notes and coins do not pay interest; they are like an interest-free loan from the people who hold them to the issuer. The issuer's profit equals the interest earned onreserves minus the expense of putting the notes and coins into circulation. These expenses are typically lessthan 1 percent of assets per year. In addition, if the notes and coins are destroyed, the issuer's net worthincreases, because liabilities are reduced but assets do not. Typically, the profits from a currency board leftafter paying all the board's expenses are roughly 1 percent of gross domestic product (GDP) a year.

Using currency issued by a currency board rather than using foreign currency, such as U.S. dollar bills,

directly captures seigniorage for the domestic government. Also, use of a domestic currency board issuerather than a foreign currency satisfies nationalistic sentiment.

Monetary policy: By design, a currency board has no discretionary powers. Its operations are completelypassive and automatic. The sole function of a currency board is to exchange its notes and coins for theanchor currency at a fixed rate. Unlike a central bank, an orthodox currency board does not lend to thedomestic government, to domestic companies, or to domestic banks. In a currency board system, thegovernment can finance its spending by only taxing or borrowing, not by printing money and therebycreating inflation.

Interest rates and inflation: An orthodox currency board does not try to influence interest rates byestablishing a discount rate like a typical central bank. The fixed exchange rate with the anchor currencyencourages arbitrage that tends to keep interest rates and inflation in the currency board country roughly thesame as those in the anchor-currency country. However, exceptions occur in countries replacing highlyinflationary central banks with currency boards. In such cases, prices for many goods are initially low interms of the anchor currency, because the domestic currency is so untrustworthy. Under a sound currencythere occurs a period of catch-up price increases; inflation, while lower than before, is higher than in theanchor-currency country. This is quite normal and does not create economic pressure to devalue thecurrency. Price increases taper and annual inflation falls to single digits, as happened in Argentina and ishappening in Estonia and Lithuania.

Relation to banks: Just as a currency board has no share in the profits of banks, it has no responsibilityfor acting as a lender of last resort to protect them from losses. Bank failures have been rare in orthodoxcurrency board systems. They have, however, been common in the recent currency board-like systems, whichhave inherited many banking problems from the central banking systems that preceded them. Historical

experience suggests that lenders of last resort usually create more problems than they solve, because theirexistence encourages banks to be less prudent than they would otherwise. Accordingly, the best policy is tolet troubled banks fail.

Though a currency board holds 100 percent or slightly greater foreign reserves, banks in a currency boardsystem are not required to imitate the currency board. Like banks in a central banking system, their reservesin excess of legal minimum requirements are typically only a few percent of their liabilities. Another way tosay this is that in a currency board system, the monetary base (M0) has 100 percent foreign reserves, butbroader measures of the money supply such as M1 (currency in circulation plus demand deposits) or M2(currency in circulation plus demand deposits plus time deposits) do not have 100 percent reserves.

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Where are currency boards appropriate?

Currency boards are worth considering in any country where the national currency has not performed as wellin the long term as the major internationally traded currencies. The long term means 10 years or more; manycurrencies have promising performance for a few years, but are unable to sustain it. The major internationalcurrencies are currently the U.S. dollar, the euro, and to a lesser extent the Japanese yen.

Among central banks, only about 50 percent in developed countries and 5 percent in developing countries

issue currencies that have performed approximately as well in the long term as the major internationalcurrencies. In most countries, therefore, establishing currency boards would significantly improve the qualityof the national currency.

Some people have claimed that currency boards are only appropriate for small economies highly open toforeign trade. Historically, though, currency boards have worked well both in relatively large, closedeconomies and in small, open ones. And no matter how large and closed a country is, there is no advantage tohaving an unsound currency issued by a central bank rather than a sound currency issued by a currencyboard.

Official dollarization (using a foreign currency as predominant or exclusive legal tender) and an orthodoxcurrency board are quite similar. The main advantage of dollarization over a currency board is thatdollarization is likely to have somewhat greater credibility because it is harder (though not impossible) to

reverse . The main advantage of a currency board over dollarization is that a currency board retainsseigniorage domestically whereas dollarization does not under the current policies of the countries issuingthe major international currencies, the most likely choices for countries interested in dollarizing.

History of orthodox currency boards

Currency boards have existed in about seventy countries. The idea of currency boards originated in Britain inthe early 1800s among a group of economists known as the Currency School. They had great politicalinfluence, and the Bank Act of 1844 was intended to convert the Bank of England into a currency board.Unlike modern advocates of currency boards, though, the Currency School did not realize that both depositsand notes that comprise the monetary base must be backed 100 percent with foreign assets in a currencyboard system. The Bank Act had no reserve requirement for deposits, and as a result, instead of convertingthe Bank of England into a currency board, the act converted it into a central bank. Because Britain was themost economically advanced country of the time, its example was influential, and many other countriesimitated British legislation.

The first successful attempt to establish a currency board occurred in the British Indian Ocean colony of Mauritius in 1849. After some experimentation, the currency board system achieved its mature orthodoxform with the West African Currency Board, established in 1912 for the British colonies of Nigeria, theGold Coast (Ghana), Sierra Leone, and the Gambia. The West African Currency Board was a model formany later currency boards. By the 1930s, currency boards were widespread in British colonies in Africa,Asia, the Caribbean, and the Pacific islands.

Currency boards have also existed in a number of independent countries as diverse as Argentina in the early1900s, the free city of Danzig (today Gdansk, Poland) in the 1920s, and Yemen. The recent currency board-

like systems, discussed below, have all been in independent countries.

The currency board system reached its greatest extent in the late 1940s, when about 50 countries hadcurrency boards. Currency board systems performed well, with low inflation, full convertibility into theiranchor currencies, and good economic growth. Even so, most fell victim to intellectual fashions of the 1950sand 1960s that favored central banking. Another reason that currency boards disappeared was that mostcurrency boards existed in British colonies, and when the colonies achieved independence theyindiscriminately replaced many existing institutions.

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The most prominent currency board today is that of Hong Kong. The Hong Kong dollar is linked to theU.S. dollar at HK$7.80 = US$1. The Chinese government has promised to retain Hong Kong's existingeconomic system for 50 years after Hong Kong reverts from Britain to China on 1 July 1997, but theChinese government is not entirely trustworthy. The Hong Kong system is not completely orthodox; since1988, the government of Hong Kong has gradually increased the power of the Hong Kong MonetaryAuthority (HKMA) to act like a central bank in some respects. In August 1998 the HKMA bought massiveamounts of Hong Kong shares on the stock market--unorthodox for a central bank, let alone a currency

board. A weakness of the Hong Kong system is that it rests more on custom than on law. The law does notrequire the HKMA to maintain a fixed exchange rate nor does it specify the precise composition of reserves.The Hong Kong system is on the borderline between currency board and currency board-like. I have writtena paper suggesting how to make it more orthodox.

More or less orthodox currency boards also remain today in the British territories of Bermuda, theCayman Islands, theFalkland Islands, and Gibraltar, as well as in the Faroe Islands, which are part of Denmark. Bermuda has capital controls for residents, who are not allowed to invest more than US$30,000 ayear abroad without permission. Since the Bermuda Monetary Authority has U.S. dollar reserves of 115percent of the monetary base, I cannot understand why the controls exist. As far as I know, no other currencyboard has ever imposed such controls on transactions with its anchor currency.

Recent currency board-like systems

Since 1991, a few countries have established currency board-like systems. Argentina  did so on 1 April1991, establishing an exchange rate of 10,000 australes (later = 1 peso) = US$1. Argentina abandoned thesystem on 6 January 2002. The Argentine episode has been a subject of great controversy and much ill-informed commentary; here are some of my writings  about it. Estonia  followed on 20 June 1992,establishing an exchange rate of 8 kroons = 1 German mark (DM). With the replacement of the mark by theeuro, the euro became the anchor currency. Lithuania, influenced by Estonia's success, did likewise on 1April 1994, establishing an exchange rate of 4 litas (the Lithuanian plural is litai) = US$1. In writings of 1990, 1991, and 1994, I proposed that the litas use the German mark as the anchor currency. Lithuaniaeventually did so, in a way, by switching from the dollar to the euro on 1 February 2002 using the prevailingdollar-euro cross rate.

To reverse a high rate of inflation and a shrinking economy, Bulgaria established a currency board-likesystem on 1 July 1997, based on an exchange rate of 1,000 leva (later 1 new lev) = DM1. Since then, theBulgarian economy has quickly recovered (see the statistics below). As stipulated in the Dayton PeaceAccord, Bosnia established a currency board-like system linked to the German mark on 1 August 1997.Statistics of the performance of the Bosnian economy remain sketchy as a result of the damage caused bythe civil war. Bulgaria and Bosnia's systems both now use the euro as their anchor currency.

These systems are not orthodox currency boards, but unorthodox "currency board-like" systems--centralbanks that retain many of their old powers, but are constrained by currency board rules regarding theexchange rate and reserves. The potential problem with currency board-like systems is that they haveloopholes that allow the central banks considerable discretionary power, defeating the purpose of having acurrency board. In Argentina, for example, the minimum foreign reserve ratio was not 100 percent, as for anorthodox currency board, but 66-2/3 percent; there was no maximum, whereas an orthodox currency board

would have had a maximum of perhaps 110 percent. In "The Problem with Pegged Exchange Rates" (writtenMay 1998, published 1999), I developed what I consider a good, simple argument crystallizing my criticismsof unorthodoxy; a restatement of this idea occurs in my article "Why Currency Crises Happen." Basically,the argument is that the unorthodox elements in currency board-like systems can delay adjustment of the realsupply of money and credit to the real demand for them, creating unnecessary monetary disturbances. So far,only Argentina's currency board-like system has collapsed, though some of the others have experienced jitters at times. (Even so, they have performed better than the monetary systems they replaced.) Steve H.Hanke's article "The Disregard for Currency Board Realities" collects key statistics of the performance of the currency board-like systems established in the 1990s.

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Brunei has an older currency board-like system that uses the Singapore dollar as the anchor currency. Themonetary authority is required to hold foreign reserves of at least 70 percent. Djibouti also has a currencyboard-like system in which notes and coins have 100 percent backing in foreign reserves, but deposits thatare part of the monetary base may not have the same requirement. Details about Djibouti's system are hard tofind.

Monetary systems sometimes mistaken for currency boards

The currency board and currency board-like systems listed here are the only ones that currently exist. Someeconomists have mistakenly characterized the monetary systems of other countries, including Singapore,Latvia, and the CFA franc zone (in Africa), as currency boards. A central bank can try to act like a currencyboard, but experience indicates that without a formal commitment embodied in law, the central bank willquickly revert to an active, managed monetary policy that is the opposite of a currency board.

Singapore had a currency board until 1973, but since then the Monetary Authority of Singapore hasmaintained a floating exchange rate. Though the Monetary Authority of Singapore holds net foreign reservesequal to about 100 percent of the monetary base, it is an unusual central bank rather than a currency board.Latvia and the CFA franc zone have never had currency boards. The Bank of Latvia currently holds netforeign reserves close to 100 percent and pegs its currency to the Special Drawing Right (SDR, a basket of major international currencies), but it has made no formal commitment to those policies, and could

discontinue them without changing the essence of its central banking system. The CFA franc has a peggedexchange rate with the French franc, last devalued in 1993. The central banks that issue the CFA franc arerequired to hold French franc reserves equal to at least 20 percent of their liabilities payable on demand(more or less the monetary base), not 100 percent like currency boards; in practice their reserves have oftenbeen close to 20 percent.

In a 1998 paper on currency boards, the International Monetary Fund (IMF) classified the EasternCaribbean Central Bank as a currency board arrangement. Other material from the IMF has not made thesame classification, however. The Eastern Caribbean Central Bank is required to hold foreign reserves equalto at least 60 percent of the monetary base, and in practice it holds reserves exceeding 90 percent. In myopinion, though, it is just over the line qualifying it as not being a currency board-like system because inprinciple it has considerable discretion to lend to commercial banks and member governments.