Currency_Board

Currency Board Basics: Definition, How They Work, and Impact

Key Takeaways

A currency board is a monetary authority that pegs the domestic currency to a foreign currency, ensuring stability and discipline.
It requires backing domestic currency with foreign reserves, often leading to stable exchange rates that enhance trade and investment.
Currency boards cannot act as lenders of last resort, limiting their capacity to respond in financial crises.
While offering stability, currency boards restrict monetary policy flexibility, potentially worsening economic downturns.

What Is a Currency Board?

A currency board is a type of monetary authority that pegs the domestic currency's value to a foreign currency, ensuring that every unit of domestic currency is backed with foreign reserves. It functions by managing the domestic currency with strict discipline and maintaining stability in trade and investment While offering stable exchange rates, currency boards restrict monetary policy flexibility, limiting the government's ability to respond independently to economic changes.

Understanding Currency Board Operations

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.

Currency Boards Compared to Central Banks

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.

Important

A currency board has less power to harm or help the economy than a central bank.

Benefits of a Currency Board System

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.

Limitations of a Currency Board System

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.

Real-World Application of Currency Boards

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.1 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.

Hong Kong Monetary Authority. "How Does the LERS Work?" Accessed Aug. 17, 2021.

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