Currency board

A currency board arrangement (CBA) is a domestic monetary regime governed by three strict rules:

(1) an exchange rate rigidly pegged to a foreign currency;

(2) the obligation for the currency issued to be freely and integrally convertible into this foreign "reserve currency"; and

(3) an obligation for the currency board to keep in its balance sheet a volume of foreign reserve currency equal to at least 100 per cent of the monetary base (that is, currency in circulation plus bank reserves).

The first generation of CBAs was the monetary core of the sterling system that reached its peak in the sterling area period. It was the major instrument of monetary integration of the most dependent British imperial territories to the motherland. By issuing its own currency against a full backing of sterling assets, a colony enjoyed the benefits of a sound local currency without the drawbacks and costs associated with using the actual sterling notes in distant lands: sterling note denominations were too large to be practical; costs related to shipping and risk of destruction or loss were high; and, furthermore, colonial authorities could capture "seignoriage revenues", that is, obtain resources from yields on reserve assets instead of letting them to the Bank of England.

The most decisive stage was the report of the Emmot Committee (1911-12) on cur- rency matters in some African colonies, which led to the building-up of the West African Currency Board (1913). The latter served as the actual prototype of the British imperial CBAs. This generalization of CBAs coincided with the end of Britain's predominance as the first international power and the beginning of its regional retreat on its own Empire. Between the Great War and the Great Depression, the United Kingdom tightened up its connections with sterling-associated countries and started to reinforce integration with territories under its dependency.

A kind of international division of labour was set up within the British Empire. Most colonial trade finance was obtained through British "overseas" banks. Local operating branches of British banks had the protection of colonial military power; they benefited from maximum financial safety provided by the security of the currency board and the unrestricted connection with London head offices. A local lender of last resort had there- fore little relevance. Indeed, the Bank of England acted as the lender of last resort for the entire Empire. British authorities established CBAs to reinforce colonial integration and monetary cohesion of its Empire. An unforeseen CBA scheme - surprisingly designed by John Maynard Keynes himself, then a senior official at the British Treasury - was also set up in 1918 in North Russia during the Russian civil war (Ponsot, 2002).

Today, Hong Kong, Djibouti, Brunei, and a few small territories (Gibraltar, the Falkland Islands, the Cayman Islands, Bermuda, Antigua and Barbuda, Dominica, Grenada, Saint Kitts and Nevis, Saint Lucia, and Saint Vincent and the Grenadines) still operate under a CBA (Ghosh et al., 2000). A most significant fact was the emergence of a second generation of CBAs in the 1990s: Argentina (1991), Estonia (1992), Lithuania (1994), Bulgaria, and Bosnia and Herzegovina (1997). Argentina abandoned its CBA in January 2002 after a severe financial and economic crisis. With Estonia's adoption of the euro in 2011, its CBA was upheld.

Contrary to the British colonial era, the second generation of CBAs has been created to fit other purposes than a strong quasi-exclusive integration with the country that issues the anchor currency. Rather, they have been conceived as an ultimate solution to end monetary and financial chaos in "emerging" economies (hyperinflation, transition process financial crises, post-war reconstruction). They have not been motivated by a desire to reinforce integration with a strong economy, but in order to boost monetary stability, economic openness and financial liberalization. They were solutions to bring about the sacrosanct credibility required by greater openness to globalized markets. In that sense, CBAs have been the instrument of the economic policies prescribed by the "Washington Consensus" during the 1990s.

The CBA's most consistent supporters were among economists of the New Classical School. Barro (1998) has recommended it in the case of Latin America and Russia. He thus remained faithful to the conceptions of the theory of rational expectations. Since any discretionary policy is doomed to failure and contain an inflationary bias, such poli- cies must be cancelled or replaced by strict unchanging rules in order to guard against all sources of instability and inflation.

The arguments against CBAs range from the claim that such monetary arrangements imply giving up the central bank's role as lender of last resort (LLR), to the claims that they involve a deflationary growth dynamic, and that they slow down adjustments to external shocks. In absence of a domestic LLR, the banking system of countries under CBAs might be extremely vulnerable (Ponsot, 2003).

To assure financial stability of their banking system, CBA countries need strengthened direct or indirect connection with the financial system of the country that issues the reference currency to balance the absence of a domestic LLR. The inelasticity of central bank money supply may have some impact on the credit supply dynamics, and thereby on economic activity. In the case where the central bank refuses all accommodation, interest rates violently increase. If the country's economy is not able to record a current account surplus, then there is a persistent stagnation or restriction of credit. To assure a favour- able growth dynamic, CBA countries need a high degree of trade and investment links with the issuer of the reserve currency.

CBAs, like dollarization regimes (see Studart, 2001), are asymmetric monetary unions. Permanent CBAs are not viable without strong monetary and financial integra- tion. So, if a country opts for a currency board, it should peg to a currency of a country that accounts for the lion's share of its own external trade. More broadly, CBAs make sense only for small economies with sufficient commercial, financial and eventually political links with the core economy. That is what happened under the first generation of CBAs.

See also:

Convertibility law; Dollarization; Hyperinflation; Lender of last resort.