What is a Currency Board
BREAKING DOWN Currency Board
In a currency board, the management of the exchange rate and money supply are given to a monetary authority that makes decisions about the valuation of a nation's currency, specifically whether to peg the exchange rate of the local currency to a foreign currency, an equal amount of which is held in reserves. Often, this monetary authority has express instructions to back all units of domestic currency in circulation with foreign currency. In this way, a currency board operates not unlike the gold standard.
The currency board then allows for the unlimited exchange of the local, pegged currency for the foreign currency. Unlike a conventional central bank, though, which can print money at will, a currency board issues domestic currency, putting additional units into circulation, only when it has the foreign-exchange rates to back it.
A currency board can only earn the interest that is gained on the foreign reserves themselves, so those rates tend to mimic the prevailing rates in the foreign currency.
Currency Boards: Where and Why?
Like most of the world's developed economies, the United States does not have a currency board. In the U.S., the Federal Reserve is a true central bank, which operates as a lender of last resort, engaging in forward contracts and trading Treasury securities in the open market. The exchange rate is allowed to float, and is determined by market forces as well as the Fed's monetary policies.
By contrast, currency boards are rather limited in their power. They essentially hold the required percentage of pegged currency that has been previously mandated, and exchange local currency for the pegged (or anchor) currency, which is typically the U.S. dollar or the euro.
Under currency board regimes, interest rates will adjust automatically. When investors switch out of the domestic currency, into the currency it is pegged against, this shrinks the domestic currency supply, raising interest rates, until investors find it attractive to hold the domestic currency, according to the Economist.
Currency board regimes are utilized for their relative stability, and rule-based nature. Currency boards offer stable exchange rates, promoting trade and investment. Its discipline restricts government actions, too, for example, wasteful or irresponsible governments can't simply print exorbitant amounts of money to pay down deficits.
Currency Board Weaknesses
Currency boards have their downsides, though, too. In fixed exchange-rate systems, currency boards don't allow the government to set their interest rates. This means that the interest rates are set by the regulatory board that controls the currency that a local currency is pegged to.
It also means that, in cases where domestic inflation is higher than inflation in the foreign country of the currency the domestic currency is pegged to, the currency of that country with a currency board is in danger of massive overvaluation, which could make it uncompetitive.
And, if investors offload their local currency quickly, en masse, interest rates can rise very quickly, compromising banks ability to maintain appropriate, legal liquidity levels. This is dangerous for countries with fledgllng banking industries.
Finally, unlike central banks, currency boards cannot act as a lender of last resort, meaning that in the event of, let's say, a banking panic, a currency board could not lend money to the bank in a meaningful way.