INTRODUCTION!

TO CURRENCY BOARDS

Kurt Schuler
This is a summary of what currency boards are and where they have existed. Read this even if you think you
know about currency boards; chances are you will learn something new. The information here was current as
of June 2002.
Central banks and currency boards
In most countries today, the monetary authority--the organization that issues the currency--is a central bank.
A typical central bank today is a wholly government-owned body, separate from the ministry of finance, that
has a monopoly of issuing notes (paper money) and coins. A typical central bank today has a high degree of
discretionary power: it is constrained by no monetary rule, such as a binding commitment to a particular
exchange rate or inflation rate.
Only a few countries, mainly in Europe, had central banks before the twentieth century. Central banking did
not became widespread in the Americas until the period between the First and Second World Wars, and did
not become widespread in Africa and Asia until after the Second World War. Until then, countries that now
have central banks had a variety of other monetary systems, which generally provided more monetary
stability than central banks have done.
Among the other monetary systems that once were widespread were currency boards. Unlike the rest of the
other monetary systems, which have all but vanished, currency boards have enjoyed a revival of interest since
about 1990. A few countries have established currency board-like systems, and others have debated whether
to have currency boards.
What a currency board is
A currency board is a monetary authority that issues notes and coins convertible into a foreign anchor
currency or commodity (also called the reserve currency) at a truly fixed rate and on demand. An orthodox
currency board typically does not accept deposits. A currency board can operate in place of a central bank or
as a parallel issuer alongside an existing central bank; cases of parallel issue have been quite rare, though.
As reserves, a currency board holds low-risk, interest-bearing bonds and other assets denominated in the
anchor currency. A currency board's reserves are equal to 100 percent or slightly more of its notes and coins
in circulation, as set by law. A currency board generates profits (seigniorage) from the difference between the
interest earned on its reserve assets and the expense of maintaining its liabilities--its notes and coins in
circulation. It remits to the government all profits beyond what it needs to cover its expenses and to maintain
its reserves at the level set by law. An orthodox currency board has no discretion in monetary policy; market
forces alone determine the money supply.
Characteristics of a currency board
The main characteristics of a currency board are as follows.
Anchor currency: The anchor currency is a currency chosen for its expected stability and international
acceptability. For most currency boards the British pound or the U.S. dollar has been the anchor currency,
though for some of the recent currency board-like systems the anchor currency is the euro. The anchor
currency need not be issued by a central bank; a few currency boards have used gold as the anchor currency.
Convertibility: A currency board maintains full, unlimited convertibility between its notes and coins and
the anchor currency at a fixed rate of exchange. Though an orthodox currency board typically does not
convert local deposits denominated in its currency into the anchor currency, banks will offer to do so for a
small fee.

A currency board has no responsibility for ensuring that bank deposits are convertible into currency board
notes. That is solely the responsibility of banks. The currency board concerns itself only with the notes and
coins that it issues.
Unlimited convertibility into the anchor currency means that in an orthodox currency board system, no
restrictions exist on current-account transactions (buying and selling goods and services) or capital-account
transactions (buying and selling financial assets, such as foreign bonds).
Reserves: A currency board's reserves are adequate to ensure that all holders of its notes and coins can
convert them into the reserve currency or commodity. Currency boards often hold reserves of 105 or 110
percent of their liabilities, rather than just 100 percent, to have a margin of protection should the bonds they
hold lose value.
Profits: Unlike bonds or most bank deposits, notes and coins do not pay interest; they are like an interestfree loan from the people who hold them to the issuer. The issuer's profit equals the interest earned on
reserves minus the expense of putting the notes and coins into circulation. These expenses are typically less
than 1 percent of assets per year. In addition, if the notes and coins are destroyed, the issuer's net worth
increases, because liabilities are reduced but assets do not. Typically, the profits from a currency board left
after paying all the board's expenses are roughly 1 percent of gross domestic product (GDP) a year.
Using currency issued by a currency board rather than using foreign currency, such as U.S. dollar bills,
directly captures seigniorage for the domestic government. Also, use of a domestic currency board issue
rather than a foreign currency satisfies nationalistic sentiment.
Monetary policy: By design, a currency board has no discretionary powers. Its operations are completely
passive and automatic. The sole function of a currency board is to exchange its notes and coins for the
anchor currency at a fixed rate. Unlike a central bank, an orthodox currency board does not lend to the
domestic government, to domestic companies, or to domestic banks. In a currency board system, the
government can finance its spending by only taxing or borrowing, not by printing money and thereby
creating inflation.
Interest rates and inflation: An orthodox currency board does not try to influence interest rates by
establishing a discount rate like a typical central bank. The fixed exchange rate with the anchor currency
encourages arbitrage that tends to keep interest rates and inflation in the currency board country roughly the
same as those in the anchor-currency country. However, exceptions occur in countries replacing highly
inflationary central banks with currency boards. In such cases, prices for many goods are initially low in
terms of the anchor currency, because the domestic currency is so untrustworthy. Under a sound currency
there occurs a period of catch-up price increases; inflation, while lower than before, is higher than in the
anchor-currency country. This is quite normal and does not create economic pressure to devalue the
currency. Price increases taper and annual inflation falls to single digits, as happened in Argentina and is
happening in Estonia and Lithuania.
Relation to banks: Just as a currency board has no share in the profits of banks, it has no responsibility
for acting as a lender of last resort to protect them from losses. Bank failures have been rare in orthodox
currency board systems. They have, however, been common in the recent currency board-like systems, which
have inherited many banking problems from the central banking systems that preceded them. Historical
experience suggests that lenders of last resort usually create more problems than they solve, because their
existence encourages banks to be less prudent than they would otherwise. Accordingly, the best policy is to
let troubled banks fail.
Though a currency board holds 100 percent or slightly greater foreign reserves, banks in a currency board
system are not required to imitate the currency board. Like banks in a central banking system, their reserves
in excess of legal minimum requirements are typically only a few percent of their liabilities. Another way to
say this is that in a currency board system, the monetary base (M0) has 100 percent foreign reserves, but
broader measures of the money supply such as M1 (currency in circulation plus demand deposits) or M2
(currency in circulation plus demand deposits plus time deposits) do not have 100 percent reserves.

Where are currency boards appropriate?

Currency boards are worth considering in any country where the national currency has not performed as well
in the long term as the major internationally traded currencies. The long term means 10 years or more; many
currencies have promising performance for a few years, but are unable to sustain it. The major international
currencies are currently the U.S. dollar, the euro, and to a lesser extent the Japanese yen.
Among central banks, only about 50 percent in developed countries and 5 percent in developing countries
issue currencies that have performed approximately as well in the long term as the major international
currencies. In most countries, therefore, establishing currency boards would significantly improve the quality
of the national currency.
Some people have claimed that currency boards are only appropriate for small economies highly open to
foreign trade. Historically, though, currency boards have worked well both in relatively large, closed
economies and in small, open ones. And no matter how large and closed a country is, there is no advantage to
having an unsound currency issued by a central bank rather than a sound currency issued by a currency
board.
Official dollarization (using a foreign currency as predominant or exclusive legal tender) and an orthodox
currency board are quite similar. The main advantage of dollarization over a currency board is that
dollarization is likely to have somewhat greater credibility because it is harder (though not impossible) to
reverse . The main advantage of a currency board over dollarization is that a currency board retains
seigniorage domestically whereas dollarization does not under the current policies of the countries issuing
the major international currencies, the most likely choices for countries interested in dollarizing.
History of orthodox currency boards
Currency boards have existed in about seventy countries. The idea of currency boards originated in Britain in
the early 1800s among a group of economists known as the Currency School. They had great political
influence, and the Bank Act of 1844 was intended to convert the Bank of England into a currency board.
Unlike modern advocates of currency boards, though, the Currency School did not realize that both deposits
and notes that comprise the monetary base must be backed 100 percent with foreign assets in a currency
board system. The Bank Act had no reserve requirement for deposits, and as a result, instead of converting
the Bank of England into a currency board, the act converted it into a central bank. Because Britain was the
most economically advanced country of the time, its example was influential, and many other countries
imitated British legislation.
The first successful attempt to establish a currency board occurred in the British Indian Ocean colony of
Mauritius in 1849. After some experimentation, the currency board system achieved its mature orthodox
form with the West African Currency Board, established in 1912 for the British colonies of Nigeria, the
Gold Coast (Ghana), Sierra Leone, and the Gambia. The West African Currency Board was a model for
many later currency boards. By the 1930s, currency boards were widespread in British colonies in Africa,
Asia, the Caribbean, and the Pacific islands.
Currency boards have also existed in a number of independent countries as diverse as Argentina in the early
1900s, the free city of Danzig (today Gdansk, Poland) in the 1920s, and Yemen. The recent currency boardlike systems, discussed below, have all been in independent countries.
The currency board system reached its greatest extent in the late 1940s, when about 50 countries had
currency boards. Currency board systems performed well, with low inflation, full convertibility into their
anchor currencies, and good economic growth. Even so, most fell victim to intellectual fashions of the 1950s
and 1960s that favored central banking. Another reason that currency boards disappeared was that most
currency boards existed in British colonies, and when the colonies achieved independence they
indiscriminately replaced many existing institutions.

The most prominent currency board today is that of Hong Kong. The Hong Kong dollar is linked to the
U.S. dollar at HK$7.80 = US$1. The Chinese government has promised to retain Hong Kong's existing
economic system for 50 years after Hong Kong reverts from Britain to China on 1 July 1997, but the
Chinese government is not entirely trustworthy. The Hong Kong system is not completely orthodox; since
1988, the government of Hong Kong has gradually increased the power of the Hong Kong Monetary
Authority (HKMA) to act like a central bank in some respects. In August 1998 the HKMA bought massive
amounts of Hong Kong shares on the stock market--unorthodox for a central bank, let alone a currency
board. A weakness of the Hong Kong system is that it rests more on custom than on law. The law does not
require the HKMA to maintain a fixed exchange rate nor does it specify the precise composition of reserves.
The Hong Kong system is on the borderline between currency board and currency board-like. I have written
a paper suggesting how to make it more orthodox.
More or less orthodox currency boards also remain today in the British territories of Bermuda, the
Cayman Islands, theFalkland Islands, and Gibraltar, as well as in the Faroe Islands, which are part of
Denmark. Bermuda has capital controls for residents, who are not allowed to invest more than US$30,000 a
year abroad without permission. Since the Bermuda Monetary Authority has U.S. dollar reserves of 115
percent of the monetary base, I cannot understand why the controls exist. As far as I know, no other currency
board has ever imposed such controls on transactions with its anchor currency.
Recent currency board-like systems
Since 1991, a few countries have established currency board-like systems. Argentina did so on 1 April
1991, establishing an exchange rate of 10,000 australes (later = 1 peso) = US$1. Argentina abandoned the
system on 6 January 2002. The Argentine episode has been a subject of great controversy and much illinformed commentary; here are some of my writings about it. Estonia followed on 20 June 1992,
establishing an exchange rate of 8 kroons = 1 German mark (DM). With the replacement of the mark by the
euro, the euro became the anchor currency. Lithuania, influenced by Estonia's success, did likewise on 1
April 1994, establishing an exchange rate of 4 litas (the Lithuanian plural is litai) = US$1. In writings of
1990, 1991, and 1994, I proposed that the litas use the German mark as the anchor currency. Lithuania
eventually did so, in a way, by switching from the dollar to the euro on 1 February 2002 using the prevailing
dollar-euro cross rate.
To reverse a high rate of inflation and a shrinking economy, Bulgaria established a currency board-like
system on 1 July 1997, based on an exchange rate of 1,000 leva (later 1 new lev) = DM1. Since then, the
Bulgarian economy has quickly recovered (see the statistics below). As stipulated in the Dayton Peace
Accord, Bosnia established a currency board-like system linked to the German mark on 1 August 1997.
Statistics of the performance of the Bosnian economy remain sketchy as a result of the damage caused by
the civil war. Bulgaria and Bosnia's systems both now use the euro as their anchor currency.
These systems are not orthodox currency boards, but unorthodox "currency board-like" systems--central
banks that retain many of their old powers, but are constrained by currency board rules regarding the
exchange rate and reserves. The potential problem with currency board-like systems is that they have
loopholes that allow the central banks considerable discretionary power, defeating the purpose of having a
currency board. In Argentina, for example, the minimum foreign reserve ratio was not 100 percent, as for an
orthodox currency board, but 66-2/3 percent; there was no maximum, whereas an orthodox currency board
would have had a maximum of perhaps 110 percent. In "The Problem with Pegged Exchange Rates" (written
May 1998, published 1999), I developed what I consider a good, simple argument crystallizing my criticisms
of unorthodoxy; a restatement of this idea occurs in my article "Why Currency Crises Happen." Basically,
the argument is that the unorthodox elements in currency board-like systems can delay adjustment of the real
supply of money and credit to the real demand for them, creating unnecessary monetary disturbances. So far,
only Argentina's currency board-like system has collapsed, though some of the others have experienced
jitters at times. (Even so, they have performed better than the monetary systems they replaced.) Steve H.
Hanke's article "The Disregard for Currency Board Realities" collects key statistics of the performance of
the currency board-like systems established in the 1990s.

Brunei has an older currency board-like system that uses the Singapore dollar as the anchor currency. The
monetary authority is required to hold foreign reserves of at least 70 percent. Djibouti also has a currency
board-like system in which notes and coins have 100 percent backing in foreign reserves, but deposits that
are part of the monetary base may not have the same requirement. Details about Djibouti's system are hard to
find.
Monetary systems sometimes mistaken for currency boards
The currency board and currency board-like systems listed here are the only ones that currently exist. Some
economists have mistakenly characterized the monetary systems of other countries, including Singapore,
Latvia, and the CFA franc zone (in Africa), as currency boards. A central bank can try to act like a currency
board, but experience indicates that without a formal commitment embodied in law, the central bank will
quickly revert to an active, managed monetary policy that is the opposite of a currency board.
Singapore had a currency board until 1973, but since then the Monetary Authority of Singapore has
maintained a floating exchange rate. Though the Monetary Authority of Singapore holds net foreign reserves
equal to about 100 percent of the monetary base, it is an unusual central bank rather than a currency board.
Latvia and the CFA franc zone have never had currency boards. The Bank of Latvia currently holds net
foreign reserves close to 100 percent and pegs its currency to the Special Drawing Right (SDR, a basket of
major international currencies), but it has made no formal commitment to those policies, and could
discontinue them without changing the essence of its central banking system. The CFA franc has a pegged
exchange rate with the French franc, last devalued in 1993. The central banks that issue the CFA franc are
required to hold French franc reserves equal to at least 20 percent of their liabilities payable on demand
(more or less the monetary base), not 100 percent like currency boards; in practice their reserves have often
been close to 20 percent.
In a 1998 paper on currency boards, the International Monetary Fund (IMF) classified the Eastern
Caribbean Central Bank as a currency board arrangement. Other material from the IMF has not made the
same classification, however. The Eastern Caribbean Central Bank is required to hold foreign reserves equal
to at least 60 percent of the monetary base, and in practice it holds reserves exceeding 90 percent. In my
opinion, though, it is just over the line qualifying it as not being a currency board-like system because in
principle it has considerable discretion to lend to commercial banks and member governments.