Currency

Understanding the Currency Board vs. Central Bank – The Zimbabwe Mail



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.

By Rebecca Baldridge

KEY TAKEAWAYS

A currency board is a monetary authority that issues notes and coins like a central bank, but it differs by not being a lender of last resort or the government’s bank.

In a currency board system, the local currency is anchored to a foreign currency (reserve currency), and the exchange rate is strictly fixed.
A currency board does not influence monetary policy but relies on supply and demand, issuing notes and coins and providing fixed-rate conversions to the anchor currency.

A currency board must hold at least 100% of the reserve currency and have a long-term commitment to the local currency, using low-interest-bearing bonds as reserves.

Unlike central banks, currency boards do not bail out failing banks, and their credibility is crucial in maintaining the stability of the local currency.

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.

To ensure proper operations, a currency board must commit to maintaining a fixed exchange rate with the anchor currency.
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 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 local currency.

Speculation can impact the stability of a currency board. If investors doubt the currency board’s ability to maintain the fixed exchange rate or believe it might act in an unorthodox manner, it can lead to fluctuations in the local currency’s value and create economic challenges.

Modern-Day Currency Boards

It has been argued that today’s currency boards are not orthodox in practice, and are 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.

Can a Currency Board Function Alongside a Central Bank?
In some cases, a currency board can coexist with a central bank, but this arrangement is uncommon. When it does happen, the roles and responsibilities of each institution need to be clearly defined to avoid conflicting policies and ensure the stability of the currency.

How Is Monetary Policy Affected in a Currency Board System?

In a currency board system, monetary policy is not determined by the currency board authority. Instead, it is influenced by the market forces of supply and demand for the local currency. This means that interest rates and other monetary policy tools are not utilized to manage the economy.

Is a Currency Board the Lender of Last Resort?

No, a currency board does not function as the lender of last resort for banks. If a bank faces financial difficulties, the currency board will not provide a financial lifeline. In practice, bank failures are less common in currency board systems, given their inherent stability.

What Role Does the Anchor Currency Play in a Currency Board?
The anchor currency, typically a strong and internationally traded currency, serves as the foundation for the local currency’s stability. The fixed exchange rate ensures that the local currency’s value is directly linked to the anchor currency, which provides confidence to businesses and investors, making the local currency more reliable.

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.

Source: Investopedia



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