A currency board is an extreme form of a pegged exchange rate. Management of the exchange rate and the money supply are taken away from the nation’s central bank, if it has one. In addition to a fixed exchange rate, a currency board is also generally required to maintain reserves of the underlying foreign currency.
Often, this monetary authority has direct instructions to back all units of domestic currency in circulation with foreign currency.
Currency boards offer stable exchange rates, which promote trade and investment.
In a crisis, a currency board can cause substantial damage by restricting monetary policy.
Under 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. Often, this monetary authority has direct instructions to back all units of domestic currency in circulation with foreign currency. When all domestic currency is backed with foreign currency, it is called a 100% reserve requirement. With a 100% reserve requirement, a currency board operates similarly to a strong version of the gold standard.
The currency board allows for the unlimited exchange of the domestic currency for foreign currency. A conventional central bank can print money at will, but a currency board must back additional units of currency with foreign currency. A currency board earns interest from foreign reserves, so domestic interest rates usually mimic the prevailing rates in the foreign currency.
Like most of the world’s large economies, the U.S. does not have a currency board. In the United States, the Federal Reserve is a true central bank, which operates as a lender of last resort. The exchange rate is allowed to float and determined by market forces, as well as the Fed’s monetary policies.
By contrast, currency boards are somewhat limited in their power. They mostly just hold the required percentage of pegged currency that was previously mandated. They also exchange local currency for the pegged (or anchor) currency, which is typically the U.S. dollar or the euro.
A currency board has less power to harm or help the economy than a central bank.
Currency board regimes are often praised for their relative stability and rule-based nature. Currency boards offer stable exchange rates, which promote trade and investment. Their discipline restricts government actions. Wasteful or irresponsible governments cannot simply print money to pay down deficits. Currency boards are known for keeping inflation under control.
Currency boards also have downsides. In fixed exchange-rate systems, currency boards don’t allow the government to set their interest rates. That means economic conditions in a foreign country usually determine interest rates. By pegging the domestic currency to a foreign currency, the currency board imports much of that foreign country’s monetary policy.
When two countries are at different points in the business cycle, a currency board can create serious issues. For example, suppose the central bank raises interest rates to restrain inflation during an expansion in the foreign country. The currency board transmits that rate hike to the domestic economy, regardless of local conditions. If the country with a currency board is already in a recession, the rate hike could make it even worse.
In a crisis, a currency board can cause even more damage. If investors offload their local currency quickly and at the same time, interest rates can rise fast. That compromises the ability of banks to maintain legally required reserves and appropriate liquidity levels.
Such a banking crisis can get worse fast because currency boards cannot act as a lender of last resort. In the event of a banking panic, a currency board cannot lend money to banks in a meaningful way.
Hong Kong has a currency board that maintains a fixed exchange rate between the U.S. dollar and the Hong Kong dollar. Hong Kong’s currency board has a 100% reserve requirement, so all Hong Kong dollars are fully backed with U.S. dollars. While the currency board contributed to Hong Kong’s trade with the U.S., it also worsened the impact of the 1997 Asian financial crisis.