In currency board systems, the rules are written in stone

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Some currency board experiments have failed terribly. Everybody can’t become a master of running with legs tied

by Shailaja and Manoj K Singh found at livemint.com

To a curious observer, a currency board system may look like someone running with legs tied. In certain situations, a currency board system could be the best way of dealing with a runaway currency.

But this remedy may not always work. Some currency board experiments have failed terribly. Everybody can’t become a master of running with legs tied.

Johnny: I am curious about a currency board system. Can you tell me more about it?

Jinny: We most commonly observe the central bank of a country performing the task of issuing the domestic currency. In fact, one of the most important jobs of a central bank is to decide how much domestic currency has to be issued because money supply directly affects interest rates, inflation and gross domestic product (GDP) growth.

As you may be aware, apart from conducting monetary policy and issuing currency notes, a central bank has to act as a lender of last resort for banks and a banker to the government.

There is nothing mechanical about doing all these jobs and a central bank has to freely exercise its judgement most of the time. Central banks follow their own rules for doing their job, but in a currency board system, you would find rules which are written in stone.

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Johnny: It would be better if you can first explain what exactly a currency board system is. And how is it different from main street central banking?

Jinny: In a currency board system, the task of issuing domestic currency is performed by an independent monetary authority which does not undertake other central banking functions such as acting as a lender of last resort for banks or acting as a banker to the government.

A currency board can’t pursue an independent monetary policy by setting short-term interest rates or by changing money supply like other central banks. A currency board has to act in a mechanical manner without any room for discretion, as if the entire central banking has been put on autopilot.

Johnny: Is that so mechanical? Can you explain how a currency board system works?

Jinny: In a currency board system, the currency board issues domestic currency only against reserves of some foreign currency. The US dollar, euro and British pound are some of the favourite foreign currencies being used by different currency boards as reserves. The exchange rate of the domestic currency remains fixed against the foreign currency being used as reserves.

A currency board must ensure that it has sufficient reserves of the foreign currency all the time, so that holders of domestic currency can convert it into the reserve foreign currency without any current or capital account restrictions at the fixed exchange rate. Maintaining a fixed exchange rate with the reserve foreign currency is the only priority of a currency board.

A currency board can’t issue domestic currency until and unless it receives the foreign currency in exchange, which it must keep as a reserve to be used only for converting domestic currency into the reserve foreign currency as and when required.

The process works mechanically like a cloakroom where you deposit your umbrella and take a receipt. In a currency board system, you deposit the reserve foreign currency and take domestic currency in exchange. If you so desire, the whole process can be fully reversed. You can surrender the domestic currency and take back the foreign currency. The currency board is able to fully honour its commitment because its domestic monetary base is 100% backed by foreign exchange reserves.

Johnny: What are the implications of such a tight working procedure?

Jinny: The restriction on issuing domestic currency, first and foremost, means that a currency board can’t print money for its government, which has to meet its commitments either by taxing or borrowing money from the market.

For governments used to huge fiscal deficits, adopting a currency board system would be like going to a rehabilitation centre.

Secondly, a currency board can’t act as a lender of last resort for commercial banks. Even during a financial emergency, rules are treated like rules. You can’t get a free umbrella no matter how heavily it might be raining.

Thirdly, a currency board has no control over domestic interest rates because it can’t adjust the money supply. The supply of domestic currency is decided by the demand of the domestic currency in the forex market.

If the demand of the domestic currency is higher, then more of the reserve foreign currency would be tendered for receiving domestic currency, which would increase the supply of domestic currency. Greater supply of domestic currency would lead to a fall in interest rates.

If the demand for domestic currency is lower, the reverse process would follow. Currency boards have to just stand up like a robot. Sometimes, acting like a robot works well but sometimes, it might lead to disaster.

Johnny: Thanks, Jinny. We will talk about the successes and failures of some famous currency boards in detail on some other occasion.

What: Some countries follow the system of a currency board which issues domestic currency.

How: A currency board issues domestic currency only against 100% reserves of a foreign currency.

Why: The 100% reserves are used to maintain a fixed exchange rate between domestic currency and foreign currency.

Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com

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