Currency Board Arrangements. Rationale for Their Introduction, Advantages and Disadvantages

I Introduction

Currency board arrangements, under which domestic currency can be issued only to the extent that it is fully covered by the central bank’s holdings of foreign exchange, were long generally dismissed as throwbacks to the colonial era. It was argued that such a rigid, rule-based arrangement was not well suited to diversified economies in many of which the authorities had developed sophisticated skills in monetary management. Instead, currency boards were seen as desirable in very small open economies (such as city-states for example). In 1960, 38 countries or territories were operating under a currency board. By 1970, they were 20 and, by the late 1980s, only 9.

In the last decade the interest for Currency Board Arrangement (hereinafter CBA) renewed because of its simplicity, transparency, and rule-bound character. It became evident after the successful efforts made by two transition economies-Estonia and Lithuania-which quickly managed to achieve credibility for their newly established currencies. In 1997, a currency board arrangement was introduced in Bulgaria to end the economic crisis. Soon after, Bosnia and Herzegovina followed. In 1998 there have been discussions on establishing a currency board arrangement in Russia. More recently the newly appointed Finance Minister of Poland initiated a debate on pegging the Polish zloty to the euro through a CBA.

This paper previews the history of the colonial and modern currency boards and presents the benefits of such a system for the newly emerged transition economies in Eastern Europe and Bulgaria especially. First, we will present a brief description of the currency board system.

1.What is a currency board?

A currency board is an institution set by law that issues notes and coins (base money) convertible on demand at a fixed rate into a foreign currency or “other” external asset.^{[1] [2]}

From the former definition we can draw the main characteristics of a CB:

Convertibility: The Currency Board (CB) is a system of fixed exchange rates. A CB exchanges automatically unlimited quantity of its notes and coins for an external reserve asset and vice versa at a fixed exchange rate. A small fee may be charged for this transaction. However, the currency board bears no responsibility for converting bank deposits into currency board base money. An orthodox CB does not act as a lender of last resort to commercial banks.

Reserves: A CB holds external assets equal to at least 100 percent of the board’s note and coins in circulation. A CB holds a portion of its reserves in extremely liquid form, such as bank deposits in top-rated international banks in the reserve-currency country, top graded short-term securities and some reserve-currency notes.

Seigniorage^[3]: Unlike securities or most bank deposits, notes and coins do not pay interest; hence they yield seigniorage to the issuer. Having a currency board instead of using foreign currency retains the profits from seigniorage at home country instead of exporting them abroad.

Inflation and interest rates: Given the fixed exchange rate between the currency board currency and the anchor currency, if trade barriers are low, inflation rate should be close to that in the reserve country^[4]. Interest rates should be the same in the two countries, in the absence of political risk and barriers to movements of funds between them.

Monetary policy: By design, a CB has no discretionary power. Its monetary policy is solely determined by the market forces and is fully automatic, it consists only in exchanging its notes and coins for the reserve currency at a fixed rate. Since a currency board’s role is strictly circumscribed, it can be more insulated from politics than central bank is.

Transparency: In order to assure its credibility, a law establishes the CB, describing its functions. A law must set its dismantlement also.

2.What a currency board is not

A currency board is not a central bank. The essential difference between the two is that a currency board maintains a fixed proportion of reserves in foreign assets, whereas a central bank does not. The power to vary the ratio of external assets to domestic liabilities enables a central bank to engage in discretionary sterilization of the reserves of commercial banks.

An orthodox CB system is a regime of fixed exchange rates, not pegged rates. It is not a lender of last resort to commercial banks. Here is a short summary of the basic differences between the two systems:

An Orthodox Currency Board System vs. a typical Central Bank

Abbildung in dieser Leseprobe nicht enthalten

II Origins of the Currency Board

1.Intellectual origin of the currency board system

In the early days of the currency board system, the alternative to currency board was not a central bank, but a competitive issue of notes by commercial banks (free banking). Early currency boards came into existence out of the concern for the safety of note issue.

The British Currency School

Like many other countries, Britain also had free banking in the 18th and early 19th centuries. Banks, that were in private hands, competed with each other in issuing bank note and also in drawing deposits in the bank vaults. In return for making loans to the government, the privately owned Bank of England soon became the only issuer of bank notes.

British economists vigorously debated the desirability of bank regulation and the state monopole in note issuing. D. Ricardo was on of the ardent proponents for a government monopoly in note issuing arguing that “seigniorage in all countries belongs to the state”. He also claimed that part of the National Bank’s reserves were to consist of gold and notes be convertible in gold on demand. An important group of economists advocated the “currency principle” from which in came to be called the Currency School. J. Pennington, a member of this group, outlined the necessity of preventing banks from expanding or contracting their gold-convertible note issues in an economically damaging manner^[5]. In order to facilitate the government supervision he proposed that note issue be monopolized by Bank of England- the largest note issuer with more than 50% of the overall issue. Pennington suggested that above a certain minimum, the Bank of England should be required to back any additional note issue 100% with gold and notes and coins issued by the Bank to be convertible in gold and vice versa. This minimum corresponded to the “hard core” of the circulation-the amount of notes that would never return to the Bank for redemption as they were indispensable to trade. According to the Currency School this minimum could be backed by British government securities rather than gold and thus avoid needless accumulation of gold.

The doctrine of the Currency school economists had two main prepositions. First, they claimed that note issue did not respond quickly to gold flows. Hence banks would continue to expand credit after a deficit occurred in the current account, worsening the inevitable credit crunch. Secondly, the regulation of note issue is more important than the one of deposits. Thus they were the first to propose a division between the note-issuing and deposit-taking activities of the Bank of England.

Note issue monopoly and the British Bank Acts of 1844

In 1844 the British government passed a law proclaiming the monopoly of Bank of England as sole bank note issuer. The Act also split the Bank of England into a note issuing and a deposit-taking department. Beyond the hard core of circulation, the Issue department was required to hold 100 percent gold reserves. The Banking Department was to handle all other business of the Bank of England. It faced no legal reserve requirements, so the Bank as a whole could sterilize inflows and outflows of gold into the banking system.

The Bank Charter Act did not really institute a currency board system ( hereinafter CBS), despite its requirements that the Issue Department holds 100 percent gold and silver reserves against note issue in excess of the hard core of circulation. The Bank of England would have been a CBS if the Banking Department were following the same rules as the Issue Department did, i.e. the 100 percent reserve requirement, or if Banking Department had been an entirely separate entity. However there are some similarities between the structure and the principles of governance of Bank of England and the CBS as described above. However the indirect effect of the doctrines of the Currency School on early British colonial currency boards was considerable for it established a predisposition against competitive note issue.

2. Early Currency Board Systems

The currency board system originated and was most widespread in British colonies where free banking prevailed before. The reason seems to have been that other European colonial powers and Japan granted banking monopolies in their colonies. The first currency board to open was that of the Indian Ocean island of Mauritius. The main desire of the British authorities was to establish a “quasi-Sterling” system, combining the retention of familiar local monetary standards with a concentration of monetary policy authority in the London Colonial Office. The British colonial currency board system gained its classic expression in the West African Currency board, which opened in 1913.

Colonial note issue before currency boards

Issue of legal tender notes by British colonial governments predated currency boards. It began as expedients to meet temporary deficits in government budgets. Initially they were often convertible at fixed rates into gold, silver, or sterling. Frequently, though, they were used to finance budget deficits by inflationary means. That led the British government to suppress most note issue by colonial governments and to introduce a CBS.

The Mauritius currency board (1849)

The Mauritius government opened the first colonial currency board in 1849, after the abandonment by the two major note-issuing banks of their rights to issue bank notes. It consisted of three commissioners appointed by the government. The board issued legal tender 5- and 10-rupee notes redeemable on demand in Indian silver rupee coins. The board was required to hold 1/3, and ideally ½, of its reserves in coins. It could hold the rest in securities. At first the board held local securities only, but soon it became investing in British securities, which were more stable than local securities during economic slumps. The total reserve of coins and securities was required to be equal to the board’s note circulation. Later (in 1934) the board switched to lire sterling as reserve currency due to the fluctuations on the silver and gold markets. The board held all of its reserves in sterling securities, and no longer in local securities.

The West African Currency Board, 1913

All British colonial boards founded before 1913 at first redeemed their notes in gold or silver coins rather than in sterling. Finally they all finished by adopting the sterling exchange standard. The first board to redeem only in sterling was the West African Currency Board, which became the prototype for later orthodox currency boards as defined in Chapter I. The motive behind the West African Currency Board was a desire to use currency issue as a source of seigniorage while avoiding the dangers of depreciation against sterling.

The proposal for its establishment came after the imperial government refused to share seigniorage from coins with West African governments. A special committee was formed, which came out with the preposition of establishing a CB. The board were to issue silver coins and notes in British West Africa; the reserves (100% of coins and note circulation) should be kept in gold and lire sterling denominated securities in London. The ratio of the securities in the total reserves corresponded to the “hard core” of circulation. The rate was set at one to one and the commission for change to ¾ percent. The Board of Directors consisted of 4 members. When Britain suspended convertibility of sterling into gold at the outbreak of WWI the WA£ remained fixed to sterling rather than to the former parity of sterling. The West African Board moved quickly towards a pure sterling-exchange standard. In its early years the West African board’s reserves were close to but not quite 100 percent. Later, in order to guard losses in its portfolio of securities, the board accumulated a 10 percent reserve in addition to its existing 100 percent reserves.

The note and coin circulation of the board waned with the prosperity of the West African colonies. After a middle term peak reflecting West Africa’s economic growth and the spread of financial institutions the circulation declined as the colonies achieved independence and established central banks to take over the board’s functions. The reasons for this decline will be discussed later in this Chapter.

The currency board system reached its greatest extent in the mid 1950s. Besides existing in almost all British colonies, it was adopted also in a number of other countries like Argentina, the Philippines, North Russia and others. They all went trough a similar process that ended up with the establishment of central banks.

3.Decline of the Currency Board system. Reasons

The currency board system did not reach its zenith until 1950s, more than a century after the first currency board was established. It then declined swiftly. Most territories with currency boards quickly established central banks after becoming independent.

How central banks replaced currency boards

The countries that replaced their currency boards with central banks were influenced by the prevailing trend in economic theorizing that favored central banks for independent nations. Several conferences of the League of Nations issued statements that central banks should be established in all developed countries that did not already have them. Another reason for the decline was the way the currency boards were constructed (flaws in the related Acts that allowed local government to buy local securities) and the outburst of independence movements in the former colonies, which was manifested by the adoption of a local currency. An independent currency was seen as a symbol of detachment from the sovereign.

Criticism of the currency board system (in 1950s)

One could ask itself what were the major reasons for the decline of the currency board system. Perhaps the most important influence was the idea that central banking was a “fashionable” and advantageous monetary arrangement than the CBS. The approaching end of colonial rule in many currency board countries provoked controversy among economists about the relative merits of the currency board system and central banking.

J. Mars, an Oxford University development economist was the first to raise the discussion. Mars’s 1948 account of the Nigerian financial system claimed that the currency board needlessly diverted funds to the reserve-currency country that could instead be used to foster economic development. This statement comes to a discussion on the opportunity cost of a currency board’s reserves. Mars and others thought that 100 percent external reserves against currency was too high a ratio. They claimed that some portion of the reserves represented a clear loss of resources, because under a less restrictive monetary system the country could instead safely use that portion to buy foreign goods. It seemed absurd that that the currency board should take funds from poor countries to invest them in foreign securities. From this perspective it looked like the currency board system was retarding the economic development.

The second charge against the currency board system was that it unnecessarily forced the money supply to follow the current account balance. The Currency School thought this to be the main advantage of a currency board’s system, but as Mars and other economists contended that it was not necessarily desirable. A nation may be better off if the supply of money (which reflects credit granted by financial institutions) is not rigidly connected to transitory fluctuations in foreign trade. Fiduciary issue of money, critics said, would afford an advantageous degree of freedom to the local supply of money.

The third charge against the currency board system was that it did not allow a discretionary monetary policy, a policy that most of the economists found more effective in promoting economic growth trough control over the interest rates charged by the commercial banks.

The final major charge against the currency board system was that it lacked a lender of last resort. Critics argued that a lender of last resort could bolster the liquidity of commercial banks and prevent a financial crisis from worsening a recession caused by a decline in exports. Also, a lender of last resort could use its powers of reserve sterilization to offset changes in the public’s holdings of currency to bank deposits and payment habits.

The charges against the currency board system made by Mars and others gained adherents as the 1950s passed. At the beginning of the next decade a number of economists and central bankers questioned the wisdom of establishing central banks in developing countries. They feared that central banks might become instrument of inflationary deficit finance. Some also pointed out the practical problems of training a sufficient number of native officials to run a central bank and to the alleged impotence of central bank policy in countries without well-developed domestic bond markets.

By the late 1950s the tide turned and central banking won the theoretical discussion, especially after Edward Nevin’s 1961 book Capital Funds in Underdeveloped Countries: The Role of Financial Institutions. Nevin argued that central banking could spur economic development more effectively than the currency board system. He also pointed out that a central bank could conduct an effective monetary policy even though no domestic bond market existed. A central bank in an underdeveloped country could influence credit by changing the minimum reserve ratio required of commercial banks. Alternatively, the central bank could rediscount loans and other assets held by commercial banks or even offer credit to the public directly. Such measures could work in backward countries even though they were rare in many advanced countries.^[6]

Were the criticisms correct?

The first of the four main charges against the currency board system in the 1950s was that holding 100 percent external reserves was wasteful. Let us consider the gain that would result from using the “hard core” reserve differently. The currency board system will be more costly only if the return on domestic assets exceeds the return on similarly risky external assets. A contradiction arises. If arbitrage is efficient, returns on similarly risky domestic and external assets should be equal, plus or minus an allowance for transaction costs. Persistently higher returns on domestic assets imply either that arbitrage is not efficient or that domestic assets are riskier than external assets of similar maturity.

The Mauritius currency board at first experimented with holding a large proportion of local bonds. During local financial crisis it needed to sell the bonds to meet demands to redeem its notes and coins. The board found that it could only sell at a great loss, if at all. British bonds paid lower interest rates, but were more liquid and less likely to drop sharply in price. The experience of Mauritius currency board influenced the practice of later boards.

The second charge against the currency board system was that it forced the money supply to shadow the current account balance, thus constraining economic growth. The scenario evoked by the critics is that CBS is deflationary when demand for notes and coins shrinks-for example if a country runs current account deficits. But if the financial system is well developed and foreign banks from the reserve country are present on the market a growth in the money supply is possible through capital account transfers and branch banking with the reserve country banks.

The third charge against currency board system was that it did not permit discretionary monetary policy. However Chwee-Huay Ow(1985) claims in her dissertation that although under the currency board system a government cannot issue high-powered money at will, it can influence the supply of money by other measures. It can impose binding minimum reserve requirements, liquidity requirements, or interest rate ceilings on commercial banks; Hong Kong and Singapore have done so (See chapter II.4). Even if the government avoids regulation, it may be able to affect the money supply by shifting its funds from inside to outside the domestic financial system.

The currency board system was also criticized for lacking a lender of last resort. Some recent studies had questioned the rationale of the existence of lender of last resort facilities as they are a potential source of moral risk and often commercial banks abuse with this source of financing. In any case the currency board in itself does not preclude government guarantee for the deposits of the public.

Other factors in the decline of the currency board system

Besides the strong theoretical criticism that existed against the currency board system, other factors contributing to the decline of the currency board system were the desire for central banks as expressions of national sovereignty, the chronic weakness of sterling under the Bretton Woods system, and the greater ease of increasing and financing government spending under central banking.

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^[1] This chapter draws heavily on Kurt Schuler(1992)

^[2] Base money consists of notes and coins in circulation, but it may also include the deposits of commercial banks in the currency board authority.

^[3] The seigniorage is defined as the profit which arises from issuing a currency, Routledge Dictionary of Economics

^[4] However the CPI index needs not to move strictly in parallel, because it includes services and nontradable goods.

^[5] This preposition was made after several financial crisis of the English banking system during 1825-1839.

^[6] Minimum reserve ratios, to which Nevin devoted particular attention, are today common in all countries.