Can Currency Boards Make Fixed Exchange Rates Credible

Argentina's 1991 monetary law requiring 100 percent foreign exchange backing for the monetary base made it an example of a currency board, in which the monetary base is backed entirely by foreign currency and the central bank therefore holds no domestic assets (Chapter 17). A major advantage of the currency board system, aside from the constraint it places on fiscal policy, is that the central bank can never run out of foreign exchange reserves in the face of a speculative attack on the exchange rate.17

Developing countries are often advised by observers to adopt currency board systems. How do currency boards work, and can they be relied on to insulate economies from speculative pressures?

In a currency board regime, a note-issuing authority announces an exchange rate against some foreign currency and, at that rate, simply carries out any trades of domestic currency notes against the foreign currency that the public initiates. The currency board is prohibited by law from acquiring any domestic assets, so all the currency it issues automatically is fully backed by foreign reserves. In most cases the note-issuing authority is not even a central bank: its primary role could be performed as well by a vending machine.

Currency boards originally arose in the colonial territories of European powers. By adopting a currency board system, the colony effectively let its imperial ruler run its monetary policy, at the same time handing the ruling country all seigniorage coming from the colony's demand for money. Hong Kong has a currency board that originated this way, although the British crown colony (as it was before reverting to China on July 1, 1997) switched from being a pound sterling currency board to being a U.S. dollar currency board after the Bretton Woods system fell apart.

More recently, the automatic, "vending machine" character of currency boards has been seen as a way to import anti-inflation credibility from the country to which the domestic currency is pegged. Thus Argentina, with its experience of hyperinflation, mandated a currency board rule in its 1991 Convertibility Law in an attempt to convince a skeptical world that it would not even have the option of inflationary policies in the future. Similarly, Estonia and Latvia, with no recent track record of monetary policy after decades of Soviet rule, hoped to establish low-inflation reputations by setting up currency boards after they gained independence.

17Strictly speaking, Argentina's version of a currency board involved a slight fudge. A limited fraction of the monetary base could be held in the form of U.S. dollar-denominated Argentine government debt. This provision was analogous to the "fiduciary issue" of domestic credit that central banks were entitled to extend under the pre-1914 gold standard.

While a currency board has the advantage of moving monetary policy farther away from the hands of politicians who might abuse it, it also has disadvantages, even compared to the alternative of a conventional fixed exchange rate. Since the currency board may not acquire domestic assets, it cannot lend currency freely to domestic banks in times of financial panic (a problem Argentina encountered, as we have seen). There are other ways for the government to backstop bank deposits, for example, deposit insurance, which amounts to a government guarantee to use its taxation power, if necessary, to pay depositors. But the flexibility to print currency when the public is demanding it from banks gives the government's deposit guarantee extra clout.

Another drawback compared to a conventional fixed exchange rate is in the area of stabilization policies. For a country that is completely open to international capital movements monetary policy is ineffective anyway under a fixed rate, so the sacrifice of open-market operations in domestic assets is costless (recall Chapter 17). This is not true, however, for the many developing countries that maintain some effective capital account restrictions—for them, monetary policy can have effects, even with a fixed exchange rate, because domestic interest rates are not tightly linked to world rates. As we saw in Chapter 17, moreover, a devaluation that surprises market participants can help to reduce unemployment, even when capital is fully mobile. The devaluation option becomes a problem, though, when people expect it to be used. In that case, expectations of devaluation, by themselves, raise real interest rates and slow the economy. By foreswearing the devaluation option, countries that adopt currency boards hope to have a long-term stabilizing effect on expectations that outweighs the occasional inconvenience of being unable to surprise the markets.

In the wake of Mexico's 1994-1995 crisis, several critics of the country's policies suggested it would do well to turn to a currency board. The subsequent crisis that started in Asia generated calls for currency boards in Indonesia, Brazil, and even Russia. Can a currency board really enhance the credibility of fixed exchange rates and low-inflation policies?

Since a currency board typically may not acquire government debt, some argue that it can discourage fiscal deficits, thus reducing a major cause of inflation and devaluation (although Argentina's experience in this area provides a counter-example). The high level of foreign reserves relative to the monetary base also enhances credibility. Other factors, however, including the banking sector's increased vulnerability, can put the government under pressure to abandon the currency board link altogether. If markets anticipate the possibility of devaluation, some of the potential benefits of a currency board will be lost, as Argentina's experience shows. For just that reason, some Argentine policymakers suggested that their country adopt a policy of dollarization, under which it would forgo having a domestic currency altogether and simply use the U.S. dollar instead. The only loss, they argued, would have been the transfer of some seigniorage to the United States. But the possibility of devaluation would have been banished, leading to a fall in domestic interest rates.

For a country with a legacy of high inflation, the most solemn commitment to maintain a currency will fail to bring automatic immunity from speculation. Even Hong Kong's long-standing link to the dollar was fiercely attacked by speculators during the Asian crisis, leading to very high interest rates and a deep recession. Currency boards can bring credibility only if countries aiso have the political will to repair the economic weaknesses—such as rigid labor markets, fragile banking systems, and shaky public finances—that could make them vulnerable to speculative attack. On this criterion, Indonesia and Brazil probably do not qualify and Russia certainly does not. With its lack of wage flexibility and unstable public finances, Argentina ulti mately failed the test. Developing countries that are too unstable to manage flexible exchange rates successfully are best advised to dispense with a national currency altogether and adopt a widely used and stable foreign money.18 Even then, they will remain vulnerable to credit crises if foreign lenders fear the possibility of default.

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