Understanding the difference between the Currency Board and the Central Bank

Understanding the difference between the Currency Board and the Central Bank

A currency board, like a central bank, is the monetary authority of a country that is in charge of issuing banknotes and coins. A currency board, in contrast to a central bank, is neither the lender of last resort, nor is it what some refer to as ‘the government’s bank,’ as some believe. In addition to operating independently, a currency board can also operate in parallel with a central bank, though the latter arrangement tends to be less prevalent.

Many economies, both large and small, have employed this little-known sort of monetary system for the same amount of time as the more popularly used central bank, and it is still in use today.

Is there a viable alternative to the Central Bank?

A currency board issues into circulation local notes and coins that are linked to a foreign currency (or commodity), which is referred to as the reserve currency, according to conventional thinking. As long as the anchor currency is a strong, internationally traded currency (typically the United States dollar, European euro, or United Kingdom pound), both the value and the stability of the local currency are directly linked to the value and stability of the anchor currency in another country (or currencies). Therefore, in a currency-board system, the exchange rate is regulated at a predetermined level.

Instead of being governed by the choices of the central bank (as it would be in a traditional central banking system), a country’s monetary policy is controlled by supply and demand under a currency board. For the most part, the currency board does nothing more than issue notes and coins and provide a service for converting local currency into the anchor currency at a fixed exchange rate.

When it comes to interest rates, an orthodox currency board cannot manipulate them by setting a discount rate; additionally, because a currency board does not lend to either banks or governments, the only way for a government to raise the money it needs is through taxation and borrowing, rather than by printing more money (a major cause of inflation). In such a system, interest rates wind up being similar to those in the anchor currency’s home market, if not the same.

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Conversions and commitments are two different things.

It is theoretically necessary for a currency board to function in order to have at least 100 percent of its reserve currency accessible and to be committed to the local currency over the long term. As a result, a currency board is required to utilize a fixed rate of exchange and to keep a minimum amount of reserves in accordance with applicable laws.

In most cases, the assets of a currency board’s anchor-currency reserves – which must correspond to at least 100 percent of all local notes and coins in circulation – are either low-interest-bearing bonds or other types of securities. A currency-board system (M0) has a money base that is 100 percent supported by foreign reserves, as a result of this arrangement. A currency board will typically retain a bit more than 100 percent of foreign reserves in order to satisfy all of its financial obligations (issued notes and coins).

An exchange rate board must also be fully dedicated to having the power to convert the local currency into the anchor currency in its entirety. In other words, there should be no restrictions on individuals or businesses exchanging their local currency for the anchor currency or conducting current or capital account operations in the anchor currency.

Beyond the Point of No Return

It is not the case that the currency board maintains bank deposits that earn interest and generate profit, as is the case with the central bank. As a result, the currency board does not serve as the financial system’s lender of last resort: if a bank is in trouble, the currency board will not intervene and save it. In spite of the fact that commercial banks are not obliged to retain even a tenth of a percent of reserves to meet liabilities (demand on deposits), some have contended that in a typical currency board system, banks fail on a very regular basis.

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What is the location of these people?

A currency board, like the central bank, has a long and illustrious history that can be traced back to the English Bank Act of 1844, which established the currency board. Generally speaking, though, most currency boards have been utilized in colonies, with the economies of the mother country and the colony being intertwined with one another.

With the decolonization of the world, several newly autonomous states chose to use a currency board system to strengthen and elevate the status of their newly issued currencies. You could wonder why such countries did not simply utilize the anchor currency in their own country (as opposed to issuing local notes and coins). The answer is that: 1) a country can profit from the difference between the interest earned on its anchor-currency reserve assets and the cost of keeping notes and coins in circulation (liabilities); and 2) decolonized countries prefer to exercise their independence through the issuance of local currency for nationalistic reasons.

Currency Boards in the modern era

When it comes to operating as the monetary authority, some believe that today’s currency boards are not orthodox in practice, but rather currency board-like systems that employ a variety of approaches to accomplish their goals. Examples include a central bank that is in situ but that is subject to rules specifying the level of reserves it must keep as well as the level of the fixed exchange rate. On the other hand, a currency board that is not required to maintain a minimum of 100 percent reserves may be in place.

The use of currency board-like systems by newly independent governments such as Lithuania, Estonia, and Bosnia and Herzegovina is now widespread (local currencies are anchored to the euro). The country of Argentina employed a currency board-like system (anchored to the United States dollar) until 2002, and numerous Caribbean countries have continued to use a currency board-like system to this day.

Speculation prompted interest rates to spike, and the value of the Hong Kong dollar plummeted during the 1997/1998 financial crisis in Hong Kong, possibly the most well-known country with an economy governed by a currency board. It is difficult to imagine how and why the Hong Kong dollar could become a target of speculation, given what we now know about currency boards.

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The Hong Kong dollar has an established exchange rate and at least 100 percent of its money base is covered by foreign reserves, making it virtually impossible to speculate in the currency (in this case, there were foreign reserves equal to three times the M0). The currency rate was set at HKD 7.80 to one US dollar (USD 1.00). Analysts assert, on the other hand, that because the currency board engaged in unconventional behavior and began implementing measures to influence and direct monetary policy, investors began to speculate whether the Hong Kong Monetary Authority would indeed use its reserves if it were determined that doing so would be necessary.

Because of this perceived shift in the currency board’s operation, as well as the currency board’s willingness – as opposed to its ability – to protect the local currency’s peg, enough pressure was applied to the HK dollar to cause it to plummet in value. When the HKMA’s economic function began to appear less authoritative, the currency board’s reputation was eroded, causing the Hong Kong economy to suffer a setback and forcing the government to reassess the authority of the monetary authority in the territory.

What’s the bottom line?

In this case, which system is preferable: the currency board or the central bank? There are no straightforward examples that might provide a solution to this question. In practice, parts of each system, no matter how inconsequential, deserve to be recognized and appreciated. Any monetary authority that wishes to function must first establish confidence. When investors begin to lose confidence in a system, the system — whether it is a currency board, a central bank, or even a combination of the two – has been declared to have failed.

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