Economic Report President

Box 7-1.—Currency BoardsA currency board is a monetary institution that only issues currencyto the extent it is fully backed by foreign assets. Its principalattributes include the following:• an exchange rate that is fixed not just by policy, but by law• a reserve requirement stipulating that each dollar’s worth ofdomestic currency is backed by a dollar’s worth of reserves in achosen anchor currency, and• a self-correcting balance of payments mechanism, in which apayments deficit automatically contracts the money supply,resulting in a contraction of spending.By maintaining a strictly unyielding exchange rate and 100percent reserves, a government that opts for a currency boardhopes to ensure credibility.The first currency board was established in Mauritius, at thattime a colony of Great Britain, in 1849. The use of currency boardseventually spread to 70 British colonies. Their purpose was to providethe colonies with a stable currency while avoiding the difficultyof issuing sterling notes and coins, which were costly to replace if lostor destroyed. The colonies also benefited from this arrangement inthat they could earn interest on the foreign currency assets beingheld in reserve. The use of currency boards peaked in the 1940s anddeclined thereafter. In the 1960s, many newly independent Africancountries replaced their currency boards with central banks, andmost other countries followed suit in the 1970s.The introduction of currency board-like arrangements in HongKong (1983), Argentina (1991), Estonia (1992), Lithuania (1994),and Bulgaria (1997) constitutes a small resurgence in their useworldwide. A currency board can help lend credibility to thepolicy environment by depriving the monetary authorities of theoption of printing money to finance government deficits. Argentina,for example, has benefited from the credibility inspired by itscurrency board regime. Argentina was prompted to adopt such aregime, which it calls the Convertibility Plan, because of a dramatichyperinflation in the 1980s and the absence of a crediblemonetary authority. Since 1991 the country has become a model ofprice stability and has achieved laudable growth rates, exceptduring the recession brought on by the tequila crisis in 1995,from which it has rebounded. By most accounts, the currencyboard has worked for Argentina.Characteristics that suit countries to be candidates for currencyboards are the following: a small, open economy; a desire forfurther close integration with a particular neighbor or trading289