A currency board is an exchange rate regime based on the full convertibility of a local currency into a reserve one, by a fixed exchange rate and 100 percent coverage of the monetary supply backed up with foreign currency reserves. Therefore, in the currency board system there can be no fiduciary issuing of money. As defined by the IMF, a currency board agreement is “a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority”. For currency boards to work properly, there has to be a long-term commitment to the system and automatic currency convertibility. This includes, but is not limited to, a limitation on printing new money, since this would affect the exchange rate.
The first currency boards appeared during the nineteenth century in Britain and France’s colonies. Since for locals of those colonies using the metropolitan currency was risky (loss or destruction of notes and coins, resources being permanently locked into the currency), the implementation of currency boards in the colonies made sense. The principle of the currency board was thus created in 1844 by the British Bank Charter Act.
The advantages of using a currency board includes low inflation, economic credibility, and lower interest rates. However, there is practically no monetary independence as monetary policies will focus in maintaining the coverage of the reserve’s monetary supply in detriment of other domestic considerations. The central bank will no longer act as a lender-of-last-resort, and monetary policy will be strictly limited to that allowed by the banking rules of the currency board arrangement.
Examples include the Bulgarian lev against the Euro, or the Hong Kong dollar against the U.S. dollar.
The following figure shows the different regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:
