Currency Board

What Is A Currency Board?

The currency board refers to a monetary authority that supplies domestic currency and, at the same time, maintains a fixed exchange rate with a foreign currency. Also, the domestic or base currency is fully backed by the forex reserves.

It is an option for countries preferring pegged exchange regimes. Furthermore, the Currency Board cannot create base money above the accumulated reserve; hence during a financial crisis, printing more money without the full backing of the forex reserve to solve financial problems is not an option in a Currency Board arrangement.

• The currency board definition portrays it as a monetary system that issues domestic currency. The currency in circulation is backed by foreign currency, and the system maintains a fixed exchange rate with a foreign currency selected as the anchor currency.
• The important features of Currency Board are a fixed exchange rate, backing requirement, unrestricted convertibility, and legal commitment.
•  It's a strong pegged exchange rate regime and contributes to lower inflation and interest rates.
• It differs from the central bank, which acts as a regulator of a country's monetary policy.

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Currency Board Explained

A currency board is a simple exchange rate and monetary system established to supply an economy with domestic currency. History demonstrates that currency boards have worked in place of central banks in several circumstances. Under this, however, no discretionary monetary policy is feasible.

The important features of Currency Board are a fixed exchange rate, backing requirement, unrestricted convertibility, and legal commitment.

• Fixed exchange rate: At a fixed exchange rate, the value of the domestic currency is tightly correlated with the value of an anchor currency. The anchor currency can be any strong foreign currency. The British pound sterling, the US dollar, or the Deutsche Mark was common examples of anchor currencies.

• Backing requirement: Fundamentally, a Currency Board must fully back the monetary base with foreign exchange reserves. The forex reserve must be adequate to change all notes and coins in circulation and the domestic currency deposits held with the Currency Board into the anchor currency at the fixed exchange rate. Domestic currency issuance should match the amount of forex reserve. The reserves can take the form of foreign cash, interest-bearing assets denominated in foreign currency, etc. In reality, to protect against the possibility that their assets' market value would decline, most boards maintain reserves that are higher than the amount of base money.

• Unrestricted convertibility: On-demand and without restriction, it converts the anchor currency into local currency and the other way around, ensuring that there is always enough base money to go around.

• Legal commitment: The guidelines for the currency board are often spelled out in the legislation. It includes the selection of an anchor currency and the exchange rate, the backing requirement, etc. This approach aims to indicate consistency and dependability to economic actors and protect the currency board from being susceptible to sudden adjustments.

Example

Let us look at the example of the currency board to understand the concept better: 

Argentina adopted a currency board arrangement in 1991. Its main goal was to combat inflation, which had been a major problem for Argentina since the middle of the 20th century, especially during the 1980s, when it particularly hurt the country with two episodes of hyperinflation in the middle of 1989 and early 1990. 

Argentina's legislative body introduced the Convertibility law on March 27, 1991, and it went into effect on April 1. The Austral, the national currency at the time, and the US dollar have a fixed exchange rate set forth based on the law, 10,000 Australes are equal to one US dollar, and the distribution of the former is linked to the amount of available central bank reserves. According to Article 4 of Argentina's central bank, BCR gold and foreign exchange reserves must make up 100% of the nation's monetary base.

Pros & Cons

There are various pros and cons. Let's look into some of them: 

Pros

• It is a strong form of pegged exchange rate option since international reserves completely back the domestic currency. 
• The main advantage is the increased credibility that lowers the inflation rate and improves fiscal performance.
• A currency's dependability and the board's rule-based nature are among its most significant advantages. In addition, like any fixed-exchange-rate system, the board provides the prospect of a stable exchange rate that encourages trade and investment.

Cons

• Currency and financial crises, such as debt crises, a sudden stop in capital flows, or banking crises, correlate with higher susceptibility to exchange rates.
• They don't lend to banks and the government and do not take the form of a lender of last resort.
• The board cannot influence monetary policies.
• They have been the target of costly speculative attacks. Although Argentina and Hong Kong SAR1 effectively used currency boards, they recently experienced recessions and substantial hikes in interest rates as speculative attacks expanded to them from other nations.

Currency Board vs Central Bank vs Dollarization

• Every country has a central bank, the lender of last resort but not every country has a Currency Board, they are also not termed as the lender of last resort, and they exercise limited control compared to the central banks.   
• Central banks can regulate the country's monetary policy. In addition, it is the custodian of the cash reserves of other commercial banks. Whereas a Currency Board cannot engage in lending to banks and the government, and they cannot influence interest rates and monetary policies.
• The process through which a nation decides to utilize a foreign currency like the US dollar to replace or use parallelly with the domestic currency for financial transactions. Currency Board arrangement is easily reversible, whereas reversing dollarization is difficult.
• A government practicing full dollarization negates the revenue from the loss of seigniorage and benefits from reduced interest rates on foreign borrowing since eliminating the danger of currency depreciation, unlike a country practicing a currency board system.

Frequently Asked Questions (FAQs)

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