Like a central bank, a currency board is a country's monetary authority that issues notes and coins. Unlike a central bank, however, a currency board is not the lender of last resort, nor is it what some call 'the government's bank'. A currency board can function alone or work in parallel with a central bank, although the latter arrangement is uncommon. This little-known type of monetary system has been around just as long as the more widely used central bank, and has been used by many economies, big and small.
An Alternative to the Central Bank?
In conventional theory, a currency board issues into circulation local notes and coins that are anchored to a foreign currency (or commodity), referred to as the reserve currency. The anchor currency is a strong, internationally-traded currency (usually the U.S. dollar, euro, or British pound), and the value and stability of the local currency is directly linked to the value and stability of the foreign anchor currency. Consequently, the exchange rate in a currency-board system is strictly fixed.
With a currency board, a country's monetary policy is not influenced by the monetary authority's decisions (per the practice in a central banking system) but rather is determined by supply and demand. The currency board simply issues notes and coins, and offers the service of converting local currency into the anchor currency at a fixed rate of exchange. An orthodox currency board cannot try and manipulate interest rates by setting a discount rate; because a currency board does not lend to banks or the government, the only means a government has to raise necessary funds is through taxation or borrowing, not by printing more money (a major cause of inflation). Interest rates in such a system end up being similar to those of the anchor currency's home market.
Conversions and Commitments
Theoretically, for a currency board to function, it must have at least 100% of reserve currency available, and have a long-term commitment to the local currency. As such, a currency board is required to use a fixed rate of exchange; it must also maintain a minimal amount of reserves, as determined by law.
The assets of a currency board's anchor-currency reserves – which correspond, at minimum, to 100% of all local notes and coins in circulation – are typically either low-interest-bearing bonds and/or other types of securities. Thus, the money base in a currency-board system (M0) is 100%-backed by foreign reserves. A currency board will usually hold a little more than 100% of foreign reserves in order to cover all of its liabilities (issued notes and coins).
A currency board must also be fully committed to the complete ability to convert the local currency into the anchor currency. This means that there should be no restrictions on individuals or businesses exchanging the locally-issued currency into the anchor one, or performing either current or capital account transactions.
Beyond the Last Resort
Unlike a central bank, a currency board does not hold bank deposits earning interest and yielding profit. Therefore, the currency board is not the lender of last resort to the banking system: if a bank is failing, the currency board will not bail it out. While a commercial bank is not necessarily required to hold even 1% of reserves to cover liabilities (demand on deposits), some have argued that in a traditional currency board system it is rare for banks to fail.
Where Are They Found?
Historically, a currency board is just as old as the central bank and, like the latter, finds its roots in the English Bank Act of 1844. In practice, however, most currency boards have been used in colonies, with the mother country's and the local country's economies being tied.
With de-colonization, many newly sovereign states opted for a currency board system to add strength and prestige to their freshly printed currencies. You may be asking why such countries did not simply use the anchor currency locally (as opposed to issuing local notes and coins). The answer is: 1) a country can profit from the difference between the interest earned on the anchor-currency reserve assets and the cost of maintaining notes and coins in circulation (liabilities); 2) for nationalistic reasons, de-colonized countries prefer to exercise their independence through the issuance of a local currency.
Modern-day Currency Boards
It has been argued that today's currency boards are not orthodox in practice, and are really currency board-like systems using a combination of methods when functioning as the monetary authority. For example, a central bank may be in place, but with rules dictating the level of reserves it must maintain and the level of the fixed exchange rate; or, conversely, a currency board may not maintain a minimum of 100% reserves. Today, newly independent states such as Lithuania, Estonia, and Bosnia have implemented currency board-like systems (local currencies are anchored to the euro). Argentina had a currency board-like system (anchored to the U.S. dollar) up until 2002, and many Caribbean states have used this kind of system up until today.
Hong Kong, perhaps the most best-known country whose economy employs a currency board, experienced a financial crisis in 1997/1998, when speculation caused interest rates to soar and the value of the Hong Kong dollar to decline. However, given what we now know about currency boards, it seems hard to imagine how and why the Hong Kong dollar could fall subject to speculation: the currency is anchored at a fixed exchange rate, with at least 100% of the currency's money base covered by foreign reserves (in this case, there were foreign reserves equal to three times the M0). The exchange rate was fixed at HKD 7.80 to USD 1.00. Analysts claim, however, that, because the currency board indulged in unorthodox behavior and began implementing measures to influence and direct monetary policy, investors began to speculate whether the Hong Kong Monetary Authority would indeed use its reserves, if deemed necessary. Thus, the perception that the currency board would no longer function in an orthodox manner, and the currency board's willingness – as opposed to its ability – to defend the local currency's peg, were enough to put pressure on the HK dollar and send it tumbling.
When the economic role of the HKMA began to seem less authoritative, the currency board lost credibility, resulting in the Hong Kong economy taking a blow and having to reevaluate the powers of its monetary authority. (Learn more about past bank crises in From Booms To Bailouts: The Banking Crisis of the 1980s.)
The Bottom Line
And so, which system is better: the currency board or the central bank? There are no simple examples that could answer this question. In practice, elements of each system, no matter how subtle, deserve recognition. Any monetary authority needs credibility to function. Once investors start losing faith in the system, the system – whether it be a currency board, a central bank, or even a little bit of both – has failed.
Tutorial: The Federal Reserve