Currency boards

A  currency board is a monetary institution that only issues currency to the extent that it is fully
backed by foreign reserves. In other words, a currency board is an extreme form of the fixed
exchange rate regime under which local currency is fully backed by the US dollar or any other
chosen currency. Its major attributes include:
1 An exchange rate that is fixed not just by policy, but by law.
2A  reserve requirement to the extent that a country’s reserves are equal to 100 percent of its
notes and coins in circulation.
3A  self-correcting balance-of-payments mechanism, where a payments deficit automatically
contracts the money supply and thus the amount of spending as well.
4No central bank under a currency board system.

Thus, in addition to promoting price stability, a currency board also compels the government to
follow a responsible fiscal policy.
The first currency board was established in Mauritius, which was then a colony of Great
Britain, in 1849. The use of currency boards eventually spread to 70 British colonies. The intro-
duction of currency board like arrangements in Hong Kong (1983), Estonia (1990), Argentina
(1991), Lithuania (1994), Bulgaria (1997), and Bosnia (1998) constitutes a small resurgence in
their use worldwide.
Characteristics of countries that are candidates for currency boards include: a small, open
economy; a desire for further close integration with a particular neighbor or trading partner; a
strong need to import momentary stability; and a well-regulated financial system. During the
Asian financial crisis of 1997–8, advocates of currency boards had pushed for their wider use –
in particular, for Indonesia, Russia, and the Ukraine. A currency board, however, is unlikely to
be successful without the solid fundamentals of adequate reserves, fiscal discipline, and a well-
supervised financial system, in addition to the rule of law.
A recent episode with the Argentine peso shows that even a currency board arrangement
cannot be completely safe from a possible collapse. The currency board structure fixed the
peso–dollar exchange rate at parity through much of the 1990s by requiring that every peso in
circulation be backed by either gold or the US dollar. Argentina’s adoption of a currency board
system in 1991 curtailed its chronic inflation dramatically and attracted a substantial amount of
foreign investment for the first few years. However, a strong dollar eventually hurt exports from
Argentina and caused a protracted economic downturn. Argentina abandoned the peso–dollar
parity in January 2002 by first devaluing the peso to Ps1.40 per dollar and then floating it com-
pletely. As shown in figure 4.1, daily peso changes have become a way of life since then.
Perhaps the most prominent form of a rigidly fixed system is dollarization, the use of the US
dollar as the official currency of the country. Several countries have adopted the US dollar as
their official currency because they have suffered currency devaluation for many years. Panama
has used the dollar as its official currency since 1907. Ecuador adopted the dollar as its official

 currency in January 2000. In January 2001, El Salvador became the third country south of the
Rio Grande to abandon its domestic currency in favor of the dollar. A country that dollarizes
removes any currency volatility, thereby eliminating the possibility of future currency crises. One
major argument against dollarization has to do with the loss of sovereignty over monetary policy.