Currency board arrangement (CBA)
A currency board is a monetary arrangement based on two simple rules. First, the exchange rate between the domestic currency and an appropriately chosen foreign currency is fixed. Ideally, the fixed exchange rate is written into law in order to signal a long-term commitment. Second, there is full convertibility between the domesticmonetary base and the foreign anchor currency.The currency board stands ready to exchange domestic into foreign currency, and vice versa, at the fixed rate, on demand, and without limit.
These two defining features have immediate and important implications. Under a currency board arrangement (CBA), every note or coin of the domestic currency in circulation is backed by foreign currency. Therefore, the currency board needs to hold a large amount of liquid foreign exchange reserves at least 100 percent of the monetary base, and perhaps more in order to provide a cushion against potential capital losses on the reserves. Domestic assets (also known as ‘‘domestic credit’’) on the balance sheet of the currency board should be zero or, more realistically, should be held constant. There should be no scope for creating money by expanding domestic credit. In practical terms, this prohibits themonetary authority fromlending to the domestic government or commercial banks. In other words, the currency board is not allowed tomonetize budget deficits or to act as a lender of last resort to troubled commercial banks. Therefore, in order to succeed, a CBA must go hand in hand with fiscal discipline and a healthy banking system.
On the continuum of exchange rate regimes, a CBA falls between a conventional fixed exchange rate and an outright monetary union. Under a conventional peg, there is only partial coverage of the monetary base by foreign reserves and there is no long-term commitment to the level of the exchange rate. Under amonetary union, a country gives up its currency altogether. A currency board arrangement is a more credible arrangement than a conventional peg but less credible than a monetary union.
Under a CBA, the adjustment mechanism for achieving external equilibrium is completely automatic. The monetary authority plays a passive role; it simply stands ready to exchange domestic notes and coins into foreign ones, or vice versa, as necessary. The money supply is endogenous and determined solely bymarket forces. If a country faces a balance of payments deficit (perhaps because private capital inflows are insufficient to cover the current account deficit), the monetary authority will face a loss of foreign exchange reserves. Under the operating rules of the currency board, the money supply will contract. In asset markets, this will push domestic interest rates up, which will attract greater private capital inflows into the country. In goods markets, the falling money supply will exert deflationary pressure, and prices and wages will tend to fall over time. This will make domestic tradable goods relatively cheaper in world markets, and the current account deficit may shrink. High interest rates and the real depreciation caused by deflation will stifle domestic aggregate demand, particularly the demand for imports, thus contributing further to the current account improvement.
This should sound familiar. It is very similar to the adjustmentmechanisms operating under the classical gold standard. In fact, some economists have argued that the gold standard was a special case of a CBA, with a commodity (gold) replacing the foreign anchor currency. Given the key role of price and wage adjustment in the mechanism just described, a successful currency board needs flexible goods and labor markets.
The history of currency boards spans approximately 150 years.There have been around 80 CBAs throughout theworld.During the colonial era, various dominions of the British Empire operated more than 70 different CBAs. Currency boards combined centralized control by the colonial center with the retention of domestic monies in the periphery. They were designed to facilitate trade and financial flows within the British Empire. Currency boards fell into intellectual disfavor and were gradually replaced by conventional central banks after the demise of colonialism in the 1950s and 1960s. Central banks better fitted the political drive for national independence. The transition also reflected the period’s intellectual climate, which was infused with a sunny optimism about the effectiveness of discretionary government policies.
Currency boards came back into fashion beginning in the early 1990s, due to a collapse of faith in discretionary monetary policy, especially in developing countries. A cursory look at some countries that have operated currency boards in the 1990s and early 2000s (Hong Kong, Argentina, Estonia, Lithuania, Bulgaria, and Bosnia and Herzegovina) shows that currency board arrangements have been successful in ending hyperinflation, facilitating the transition to a market economy or to national independence, assisting postwar reconstruction, and restoring stability in an international financial center plagued by political uncertainty and banking crises. CBAs were also proposed in the aftermath of macroeconomic crises in Indonesia, Russia, Brazil, and Turkey, although none of these proposals ultimately came to fruition. Modern CBAs have been subject to occasional speculative attacks Hong Kong in 1997, and Argentina in 1995 and 2001. In general, exits from CBAs have been uneventful, with the single spectacular exception of Argentina in early 2002.
Most real-world CBAs have reserved some degree of discretionary powers, and thus deviate from the definition of an orthodox currency board. The ratio of foreign exchange reserves relative to the monetary base may be allowed to dip below 100 percent. This coverage ratio may also be allowed to go above 110 115 percent in order to sterilize capital inflows, finance a lender-of-last-resort function, or smooth fluctuations in domestic interest rates.Themonetary authorities in almost all contemporary currency boards have reserved the right to change the required reserve ratio for commercial banks, which might thwart the operation of the automatic adjustment mechanism described earlier. (The monetary authority regains some degree of control over the broader money supply.) Almost all modern CBAs have volatile domestic assets on their balance sheets.
Argentina’s currency board arrangement was the one with the most loopholes, which probably contributed to its ultimate demise. First, Argentina’s CBA was allowed to lend to the government. Second, throughout 2001 the long-term commitment to the fixed exchange rate was undermined by switching the peg from the U.S. dollar to a currency basket, and by instituting a complicated scheme of export subsidies and import surcharges, which amounted to a sneak devaluation.
Debating the Pros and Cons
Professional economists have advanced various arguments about the advantages and disadvantages of CBAs. Perhaps the single biggest advantage of a currency board is its simplicity and transparency. It may enable a government to commit credibly to monetary discipline at the expense of flexibility. In essence, through the currency board, the monetary authority can import the anti-inflationary credibility of the central bank issuing the anchor currency, typically the U.S. Federal Reserve or the European Central Bank. The domestic monetary authority becomes a mere warehouse for foreign cash.
A credible CBA reduces currency and default risk, which leads to lower domestic interest rates. It can boost the development of long-term financial markets, which are sorely lacking in many developing countries. By reducing transaction costs, the fixed exchange rate can promote trade and foreign direct investment. Finally, by establishing monetary discipline, a currency board can serve as a catalyst for a broad range of other reforms.
A serious drawback of currency boards is that they make the adopting country more vulnerable to external shocks, particularly terms-of-trade shocks, large capital inflows or outflows, or shocks emanating from the country issuing the anchor currency. Arguably, high interest rates in the United States and the strength of the dollar against the euro and the Japanese yen contributed to the demise of Argentina’s CBA, in addition to lack of fiscal discipline within the country, especially at the provincial level.
As Argentina’s experiencewith deflation in 1999 2001 also demonstrates, currency boards (or indeed fixed exchange rates in general) are probably not a good monetary arrangement for relatively closed economies. The less open the economy is, the larger the real depreciation necessary to eliminate a given balance of payments deficit. Under a fixed exchange rate, real depreciation can happen only through a fall in domestic prices. Such price adjustments can be slow and painful.
One reason to introduce a CBA is to arrest high inflation, but currency boards can generate overvalued real exchange rates and large current account deficits. Real appreciation results from the combination of a fixed nominal exchange rate and persistent domestic inflation. The introduction of a currency board can also be burdensome and timeconsuming. In order to make the arrangement credible, policymakers must build political consensus, rewrite laws, and reorganize institutions.
Critics of CBAs have pointed out that countercyclical monetary policy is impossible under a currency board arrangement, and therefore output, employment, and priceswould be more volatile under such an arrangement. Proponents of CBAs have countered that ending discretionary monetary policy is the intended purpose of such institutional arrangements: discretionary monetary policies in developing countries have been the prime source of macroeconomic instability, and currency boards have helped to restore macroeconomic stability by imposing a monetary straitjacket on the government. Monetary policy is an extension of fiscal policy printing money is a government’s revenue source of last resort. Therefore, a currency board can be beneficial in imposing a hard budget constraint on the country’s treasury.
Opponents have noted that currency boards either abolish or sharply curtail the capacity of themonetary authority to serve as a lender of last resort to the banking system.Proponents counter that a lender of last resort function is still possible under a CBA through assistance fromthe treasury, a deposit insurance scheme, or contingent credit lines from abroad. Bailing out domestic banks involves redistribution of income, and a currency board removes a nontransparent( andtherefore politically cheap) tool ofincome redistribution. By making bank bailouts more politically costly and therefore less likely, a currency board limits the moral hazard problem of the banking system( the problemof a party insulated fromrisk engaging in riskier behavior). In essence, it imposes a hard budget constraint on domestic financial institutions.
Currency boards are unable, by definition, to create money by expanding domestic credit. Therefore, they cannot earn extra seigniorage through discretionary money creation. Currency boards still make profits on the difference between interest earned on their assets (highly liquid foreign securities) and their operating costs. Seigniorage revenues are somewhat lower under currency boards than under conventional central banks, however, both because CBAs cannot expand domestic credit and because foreign reserves may pay a somewhat lower interest rate than domestic assets. Of course, many economistswould count the reduction in seigniorage as a benefit of currency board arrangements, given that it is an inefficient and nontransparent way of raising revenue.
The Empirical Record
Although theoretical arguments have dominated the debates about currency boards, little empirical work has been undertaken on the subject.Themost authoritative empirical analysis available (Ghosh, Gulde, andWolf 2000) finds that currency boards are associated with lower inflation than either floating or conventional fixed exchange rate regimes. This result is highly robust. Currency boards also appear to be associated with higher rates of gross domestic product (GDP) growth, although the reasons for this are not clear. It may be that countries with better overall economic policies selfselect in choosing to establish a currency board. It may be that most countries introduce a currency board following a severe macroeconomic crisis, and the better growth performance observed in the first few years of the new arrangement reflects a postcrisis ‘‘rebound effect.’’ At the very least, currency boards have not been associated with lower GDP growth rates, although there is some evidence that output tends to bemore volatile. Finally, CBAs appear to be associated empirically with lower money supply growth rates, smaller budget deficits, and better export performance.
In conclusion, a currency board arrangement offers significant benefits but also has serious drawbacks. Although it is neither a quick fix nor a panacea for all economic ills, in some cases it can deliver monetary discipline and low inflation. See also convertibility; currency substitution and dollarization; discipline; exchange rate regimes; expenditure changing and expenditure switching; foreign exchange intervention; gold standard, international; impossible trinity; international reserves; lender of last resort; money supply; quantity theory of money; reserve currency; seigniorage; sterilization