Currency Board

A currency board ( rare currency board or monetary authority ) is an exchange rate arrangement where a country unilaterally fixes the exchange rate of the domestic currency to a foreign currency. The difference to a simple system with fixed exchange rates is the strong institutionalization of the currency board. This is intended to build trust in the international financial and foreign exchange markets in order to improve integration in the markets and to obtain favorable terms for debt. The prerequisite is that the currency board is internationally recognized as credible.

  • 6.1 preconditions
  • 6.2 credibility 6.2.1 Measures

Features

A currency board is characterized by the following features mainly:

  • There is a fixed exchange rate between the local currency and a foreign currency (the anchor currency).
  • Each market participant has the right to change at any time at the fixed exchange rate, an arbitrarily high amount of home currency into the anchor currency.
  • The money supply of the domestic currency must be entirely covered by the foreign currency to be (this is also defined by law as a rule). Since foreign securities may decline in value, the coverage is usually at 105 to 110 percent.
  • The Government is committed to this system in the long run. Frequently, therefore, this system is required by law, sometimes even in the laws of the constitution. As an important prerequisite to ensure the credibility of the currency board, a consensus must exist on its necessity beyond the boundaries of political parties beyond. A currency board is no longer credible, if it is provided by decision-makers in question.

Operation

The core of the mechanism by which a currency board can have a stabilizing effect on the domestic economy, is the self-imposed obligation to cover the domestic money supply by foreign money or securities, and the automatic control of the money supply in the domestic market.

The central bank has to be no effect on the money supply in the country, because this can not be higher than the stocks of foreign currency to cover in this system. The money supply is thus capped. Therefore, the function of the central bank is limited to the changing of money and the monitoring of the coverage.

Nor can the central bank influence the level of foreign exchange reserves. This can rather be increased only by a surplus in the current account. Conversely, a deficit in the current account leads to a reduction of the money supply in the domestic market.

If the current account is negative, the reduction in the money supply leads to an increase in domestic interest rates, which in turn brings a fall in domestic demand with it. Due to the declining prices of goods, the demand to domestic products abroad. The higher exports bring the current account back into balance. The same applies to a current account surplus.

In a flexible exchange rate arrangement, a devaluation of the domestic currency could make exports more attractive. However, since this is not possible under a currency board system, the adjustment of the prices of goods must be made. The central bank of the anchor currency country thus determines both the money supply and indirect foreign exchange reserves in the country of the currency board. The government and the Central Bank in the currency board country have no way to influence the economy through monetary policy. For example, it is not possible, using the increase in the credit supply to improve the economy.

The currency board must be precisely defined and be free from political influence.

Unlike a monetary union or the introduction of foreign currency as means of payment in Germany ( dollarization or Euroisierung ) there is a Seignioragegewinn for the central bank.

Types of currency board

A distinction between a pure and a modified currency board. In a pure currency board arrangement, the central bank has no way to help banks in trouble. It thus takes its role as lender of last resort is not true. In a modified scheme, the domestic currency is not only covered 100 percent, but it is applied excess reserves with the central bank can intervene in an emergency.

Examples of currency boards

During the 20th century there were about sixty examples of the introduction of a currency board. This primarily former colonies. But Russia, tied its currency from time to time to the British pound. The Free City of Danzig introduced a currency board also one with ties to the pound.

After a long time been of the opinion that a currency board is a throwback to the days of colonial empires.

Lately, however, to greater interest in this exchange rate system because it has proven itself especially in crises. Thus, Hong Kong has ( single currency board in Asia) during the Asian crisis devalue its currency does not have to. This was on the one hand due to the relatively healthy banking system of Hong Kong, on the other hand also to the already long-established currency board. Another successful example of the application of a CBA is Estonia, which stabilized its economy with the help of the currency board and integrated into the Western economic system.

The Argentine currency board (1991-2002) is evaluated by economists in retrospect differently: on one hand it contributed to a huge decline in inflation rates in the country, but the system proved since the Brazilian crisis no longer adapted to the latest, to solve the country's problems because a high public debt led to an erosion of credibility of the system and since the Argentine peso was overvalued real getting stronger, what greatly reduced the competitiveness of the country 's export industry.

Currency board with the euro

Some countries have pegged their currency notes with a currency board to the euro. Partial had the countries before the introduction of the euro under a currency board with the D - Mark or the French franc. The following currencies are linked to the Euro through a currency board:

  • Bosnia and Herzegovina, 1 EUR = 1.95583 BAM ( Bosnian convertible mark corresponds to the price of the Deutsche Mark )
  • Bulgaria, 1 EUR = 1.95583 BGN ( Bulgarian Lev corresponds to the rate of the D - Mark )
  • CFA franc, 1 EUR = 655.957 XAF / XOF (100 CFA correspond to the rate of 1 French franc )
  • CFP Franc, 1 EUR ≈ 119.33174 XPF (1000 CFP franc = 8.38 €, formerly 55 French francs )
  • Cape Verde, 1 EUR = 110.265 CVE ( Cape Verde Escudos)
  • Comoros, 1 EUR = 491.9677 KMF ( Comorian francs )
  • Lithuania, 1 EUR = 3.4528 LTL ( Lithuanian Litai )

In addition to these currencies even more are linked to the euro at a fixed fluctuation.

Many countries have not, with a basket of currencies but at least partially tied its currency to the euro as a whole. According to German Bundesbank, this applies to the world for about 50 countries. In most cases, the euro is in the currency baskets but only to a small extent, holds the largest share of the U.S. dollar.

Sense of the currency board

There is disagreement about the cases in which the introduction of a currency board is more useful than another exchange rate system. Tend to be a currency board is more suitable for small countries, because the system contributes to a higher political credibility, which leads to a lower estimate of the risk by the foreign market participants. The country can borrow in the wake cheaper abroad because it has to pay a lower risk premium. In addition, the free convertibility limits the risk of an outflow invested capital abroad ( capital flight ), because it is always ensured that every sum of the domestic money can be exchanged into foreign currency. The demand for foreign currency thus decreases.

If a currency board works well and is credible, it offers the country a number of advantages:

  • The country is integrated into the world capital markets. Trade between the currency board country and the anchor currency country is simplified by the elimination of exchange rate risk.
  • The country can be. Due to the adaptation of the political and economic system to which it is forced by the introduction of the currency board, relatively quickly build a reputation This encourages investment from abroad, especially from the anchor currency country. This point is particularly acute for transition economies.
  • Is a currency board introduced, it generally requires a strong political majority in parliament to push through changes to laws that are associated with the currency board. This makes it harder to take out short-term political reasons in the interest of short-term success influence on monetary policy.
  • The currency board forces to break the cycle of wage and price increases. This cycle, which leads to inflation, is not possible under a currency board system, because the money supply can not be increased arbitrarily. In a managed floating system, the central bank would react to such a circuit with a devaluation. Is there a currency board system, employers and employees need to be aware that wages and prices must be competitive and to agree accordingly. As mentioned above, due to the stability of the exchange rate that prices and wages of the interior must be flexible.

The disadvantages or risks of a currency board are:

  • Domestically, no monetary policy be made, which is the country of the anchor currency independently. The Government may, for example, domestic interest rates not set, but apply the same rates as in the country of the anchor currency, possibly with a certain risk premium.
  • If inflation in the currency board country is higher than in the country of the anchor currency, so there is a real appreciation of the domestic currency. This means a competitive disadvantage for the country with a currency board.
  • In a currency board system the central bank or government has no way to help in the event of a banking crisis by means of loans.

Implementation

Preconditions

In order to introduce a currency board successfully, the following requirements must be met:

  • The position of the central bank as a lender of last resort must be abolished.
  • Supervisors must be solid, commercial banks have to keep oneself adequate reserves.
  • The reserves of the Central Bank must be converted into the anchor currency.

Credibility

Like the system of a fixed exchange rate requires the use of a currency board, a high level of discipline in the country that unilaterally binds its exchange rate to the other country. The greatest threat to a currency board is that market participants do not expect the fixed exchange rate remains in the long run. Then it can be assumed that the country can not borrow at such reasonable conditions as with a fixed exchange rate, of which a long inventory is expected.

Measures

Political instability in the country is also a threat to the fixed exchange rate, since it leads to a reduction in systemic credibility.

To achieve credibility, the government may take the following measures:

  • Commitment to a change of the real economic system if necessary ( as in the former planned economies of Central and Eastern Europe ).
  • Establishment of a sound banking system, and a functioning banking supervision.
  • Occupation of the currency board with credible people.
  • Legal establishment of the currency board system, which makes it difficult, because of daily politics to change something at the exchange rate policy once elected. For example, could be located abroad, the foreign currency reserves.
  • Reducing the national debt.
  • Wages and prices of goods have to be flexible, so that they can fall if a negative current account balance, to stimulate the balancing imports and exports of capital goods.

Does the currency board, the domestic currency and the anchor currency are perfect substitutes. The shareholders are then indifferent attitude of respect to a domestic or foreign money.

Credentials

Financial market Currency substitution Dollarization#Euro Gdańsk Argentina CFP-Franc Cape Verdean escudo Capital (economics) Capital outflow
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