What Exactly Is a Currency Board?
A currency board is a very large form of exchange that is constantly changing. If a country has a central bank, that bank will lack the authority to control exchange rates and revenue. In addition to maintaining fixed exchange rates, the currency board often also needs to maintain balance between foreign currencies.
Main Points
- A currency board is an extreme form of a pegged exchange rate.
- 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.
How a Currency Board Operates
The management of exchange rates and revenues under monetary policy is the responsibility of the monetary authorities, who are responsible for determining the value of a country’s currency. Financial regulators are usually given direct instructions to buy back all foreign currency in circulation in the country. If all of the domestic currency is backed by foreign currency, this is called a 100% demand. The utility board has a 100% requirement and operates like a strong gold standard.
A currency board allows the domestic currency to be converted into foreign currency. The central bank can print money at any time, but the currency board must supplement the resulting surplus with foreign currency. Banks make profits from their foreign investments, so domestic interest rates often follow the interest rates of foreign funds.
Currency Boards vs. Central Banks: What’s the Difference?
The United States, like many of the world’s major economies, does not have a currency board. In the United States, the Federal Reserve is the central bank and lender of last resort. Exchange rates are allowed to float, determined by market forces and the Federal Reserve’s monetary policy.
Currency boards, however, have limited authority. Most hold only the fixed funds at the previously specified rate. They also convert local currencies into a pegged currency (or stablecoin), usually the US dollar or euro.
Benefits of a Currency Board System
Financial systems are often praised for their relative stability and status-based policies. Financial institutions provide stable exchange rates and help promote trade and investment. Their discipline prohibits government behavior. Corrupt or irresponsible politicians cannot print money to finance their deficits. Profitable companies are known for controlling inflation.
Negative Aspects of Currency Boards
Financial institutions also have their disadvantages. Because there is a constantly changing exchange rate, a currency board does not allow the government to set interest rates. This means that the interest rate will mostly be determined by the economy in a foreign country.
Currency boards guide the monetary policy of many countries by pegging local currencies to foreign currencies. For example, suppose a central bank raises interest rates during a currency exchange period to protect against inflation. The Central Bank will reflect the interest rate increase to the domestic economy without discriminating between villages. If a country is already in recession as a result of the presidential elections, increasing interest rates will make the situation worse.
Currency boards can lead to greater losses during times of crisis. If investors continue to sell their bonds rapidly, interest rates will rise rapidly. This increases the ability of banks to maintain necessary capital and have sufficient liquidity. In the event of a banking crisis, the monetary authority will not be able to provide reasonable credit to banks.
A Closer Look at Real-World Currency Board Examples
Hong Kong has a currency board that controls the exchange rate between the US dollar and the Hong Kong dollar. Hong Kong’s currency board has a 100% reserve requirement, so all of Hong Kong’s currency is backed by the US dollar.
