The main qualities of an orthodox currency board are:
A currency board's foreign currency reserves must be sufficient to ensure that all holders of its notes and coins can convert them into the reserve currency.
A currency board maintains absolute, unlimited convertibility between its notes and coins and the currency against which they are pegged, at a fixed rate of exchange, with no restrictions on current-account or capital-account transactions.
A currency board only earns profit from interest on foreign reserves, and does not engage in forward-exchange transactions. These foreign reserves exist because local notes have been issued in exchange, or because commercial banks must, by regulation, deposit a minimum reserve at the Currency Board. generates a seignorage revenue. is the revenue on minimum reserves
A currency board has no discretionary powers to affect monetary policy and does not lend to the government. Governments cannot print money, and can only tax or borrow to meet their spending commitments.
A currency board does not act as a lender of last resort to commercial banks, and does not regulate reserve requirements.
A currency board does not attempt to manipulate interest rates by establishing a discount rate like a central bank. The peg with the foreign currency tends to keep interest rates and inflation very closely aligned to those in the country against whose currency the peg is fixed.
Consequences of adopting a fixed exchange rate as prime target
The currency board in question will no longer issue fiat money but instead will only issue one unit of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as higher deposits of the exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank.
Pros and cons
The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners. Typically, currency boards have advantages for small, open economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.
Examples in recent history
More than 70 countries have had currency boards. Currency boards were most widespread in the early and mid 20th century.. Hong Kong operates a currency board, as does Bulgaria. Estonia had a currency board fixed to the Deutsche Mark from 1992 to 1999 when it switched to fixing to the Euro at par. The peg to the Euro was upheld until January 2011 with Estonia's adoption of the Euro. This policy is seen as a mainstay of that country's subsequent economic success. Argentina abandoned its currency board in January 2002 after a severe recession. To some, this emphasised the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. However, Argentina's system was not an orthodox currency board, as it did not strictly follow currency board rules - a fact which many see as the true cause of its collapse. They argue that Argentina's monetary system was an inconsistent mixture of currency board and central banking elements. It is also thought that the misunderstanding of the workings of the system by economists and policymakers contributed to the Argentine government's decision to devalue the peso in January 2002. The economy fell deeper into depression before a recovery began later in the year. The British Overseas Territories of Gibraltar, the Falkland Islands and St. Helena continue to operate currency boards, backing their locally printed currency notes with pound sterling reserves. A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.
