This paper provides a comprehensive analysis of the attractions and disadvantages of currency board arrangements in their various institutional configurations. It asks what defines a currency board arrangement, what are their strengths and weaknesses, and what constraints they place on macroeconomic policies. It also reviews country experiences with these arrangements.
Currency board arrangements (CBAs) have undergone a revival.1 Four countries have undertaken IMF-supported adjustment programs with a CBA, Argentina, Djibouti, Estonia, and Lithuania. Bosnia and Herzegovina and Bulgaria are each about to establish one. El Salvador expressed interest in establishing one as a way to enhance credibility and policy transparency. For the same reasons, proponents of CBAs have made the case for establishing them in other countries, such as Mexico following the 1995 crisis, Peru, Brazil, and Russia.
CBAs may appear attractive to small open economies with limited central banking expertise and incipient financial markets, or to countries that wish to preserve the benefits of belonging to a broader trade or currency area, or envisage joining a currency union. In addition, they may be attractive to countries where lack of credibility severely constrains the effectiveness of monetary policy or exposes the economy to recurrent currency crises and high risk premiums (Box 3). However, a CBA cannot of itself create credibility unless accompanied by firm supporting policies. Without such policies, credibility will remain low, which will undermine the sustainability of the CBA itself.
While large foreign reserve holdings can strengthen a CBA, using them actively for LOLR or monetary operations might be seen as conflicting with its basic principles of limited discretion. It seems more likely, however, that as long as sufficient resources are available and that the authorities’ actions follow clearly specified rules, some flexibility can add to the sustainability of a currency board and thus enhance its credibility. Institutional arrangements, operational procedures, and monetary and prudential instruments can be designed to reduce risks of a systemic liquidity crisis while limiting discretionary interference from the monetary authorities. In addition, public debt policies can be reformed to limit the risk of a debt crisis. Nevertheless, some LOLR support may well be needed—preferably under central bank control—to contain financial sector problems at an early stage and avert contagion risks. This should be arranged in a manner that addresses systemic problems in the banking system, while seeking to avoid bailouts of insolvent banks. Indeed, the existence of such support facilities can enhance confidence in the domestic financial system, and hence lower intermediation spreads. To build up reserves to provide such support, CBAs may wish to set higher reserve requirements or to introduce liquidity requirements in foreign currency. CBAs can also assume traditional monetary functions, within clearly specified bounds, provided they have sufficient credibility and hold adequate excess reserves.
Although it might be argued that in the setting of a CBA all balance of payments disequilibria should adjust automatically, experience has shown that when sufficiently large shocks impinge upon the domestic economy, the government may need to implement active measures to maintain external balance. Therefore, the fundamental rationale of IMF support for adjustment programs—to provide members with the opportunity to correct disequilibria in their balance of payments without resorting to disruptive measures such as trade and payments restrictions—is as valid in the context of a CBA as in a conventional fixed exchange rate case.