Course_Economic Policy

Educational and Qualification degree: Bachellor of Economy

Currency board

Prof. Dr. Rumen Gechev

Chief Assist. Dr. Ivan Bozhikin
Ph.D. Neda Muzho
Contents:
•Classical and applied models, specifics for
1 the Bulgarian model

•Advantages and disadvantages

2

•Results of its application in Argentina, Estonia

3 and Lithuania

•Outcomes of the Currency Board in Bulgaria

4
What Is a Currency Board?

 A currency board is an extreme form of a pegged exchange rate.

Management of the exchange rate and the money supply are
taken away from the nation's central bank, if it has one. In addition
to a fixed exchange rate, a currency board is also generally
required to maintain reserves of the underlying foreign currency.
What Is a Currency Board?

 A currency board is an extreme form of a pegged exchange rate.

 Often, this monetary authority has direct instructions to back all units
of domestic currency in circulation with foreign currency.
 Currency boards offer stable exchange rates, which promote trade
and investment.
 In a crisis, a currency board can cause substantial damage by
restricting monetary policy.
How a Currency Board Works

 Under a currency board, the management of the exchange rate and

money supply are given to a monetary authority that makes decisions
about the valuation of a nation’s currency. Often, this monetary
authority has direct instructions to back all units of domestic currency in
circulation with foreign currency. When all domestic currency is backed
with foreign currency, it is called a 100% reserve requirement. With a
100% reserve requirement, a currency board operates similarly to a
strong version of the gold standard.
 The currency board allows for the unlimited exchange of the domestic
currency for foreign currency. A conventional central bank can print
money at will, but a currency board must back additional units of
currency with foreign currency. A currency board earns interest from
foreign reserves, so domestic interest rates usually mimic the prevailing
rates in the foreign currency.
How a Currency Board Works

 The currency board allows for the unlimited exchange of the

domestic currency for foreign currency. A conventional central
bank can print money at will, but a currency board must back
additional units of currency with foreign currency. A currency board
earns interest from foreign reserves, so domestic interest rates usually
mimic the prevailing rates in the foreign currency.
Currency Boards vs. Central Banks
 The U.S. does not have a currency board. In the United States,
the Federal Reserve is a true central bank, which operates as a lender of
last resort. The exchange rate is allowed to float and determined by
market forces, as well as the Fed's monetary policies.
 By contrast, currency boards are somewhat limited in their power. They
mostly just hold the required percentage of pegged currency that was
previously mandated. They also exchange local currency for the
pegged (or anchor) currency, which is typically the U.S. dollar or the
euro.
Advantages of a Currency Board

 Currency board regimes are often praised for their relative stability a
nd rule-based nature. Currency boards offer stable exchange rates,
which promote trade and investment. Their discipline restricts gover
nment actions. Wasteful or irresponsible governments cannot simply
print money to pay down deficits. Currency boards are known for ke
eping inflation under control.
Disadvantages of a Currency Board

 Currency boards also have downsides. In fixed exchange-rate systems, currency

boards don’t allow the government to set their interest rates. That means economic
conditions in a foreign country usually determine interest rates. By pegging the
domestic currency to a foreign currency, the currency board imports much of that
foreign country's monetary policy.
 When two countries are at different points in the business cycle, a currency board
can create serious issues. For example, suppose the central bank raises interest rates
to restrain inflation during an expansion in the foreign country. The currency board
transmits that rate hike to the domestic economy, regardless of local conditions. If the
country with a currency board is already in a recession, the rate hike could make it
even worse.
 In a crisis, a currency board can cause even more damage. If investors offload their
local currency quickly and at the same time, interest rates can rise fast. That
compromises the ability of banks to maintain legally required reserves and
appropriate liquidity levels.
 Such a banking crisis can get worse fast because currency boards cannot act as a
lender of last resort. In the event of a banking panic, a currency board cannot lend
money to banks in a meaningful way.
Real World Example of a Currency Board

 Hong Kong has a currency board that maintains a fixed exchange

rate between the U.S. dollar and the Hong Kong dollar. Hong Kong's
currency board has a 100% reserve requirement, so all Hong Kong
dollars are fully backed with U.S. dollars.1While the currency board
contributed to Hong Kong's trade with the U.S., it also worsened the
impact of the 1997 Asian financial crisis.
 Argentina adopted the currency board in March 1991 to put an
end to a long history of large macroeconomic imbalances and high
inflation that culminated in the hyperinflation process of 1989-91. The
regime has been extremely successful in restoring macroeconomic
stability and ensuring low inflation. The adoption of a tight fiscal
stance, and of sound polices to strengthen the financial system
were critical to ensure the resilience of the economy to respond to
adverse external shocks.
Currency Board In Bulgaria
 Currency board was introduced in Bulgaria in July 1997. It was suggested by the
International Monetary Fund as an alternative to address economic policy
dilemmas in the country. Bulgaria experienced hyperinflation in the fall of 1996
and early 1997.
 Hyperinflation is associated with a monthly rate of price increase exceeding 50
per cent. It is a serious macroeconomic problem and usually takes place as a
result of internal economic and political crisis associated with failed or
inadequate response to external shocks and big domestic and external debt. All
inflationary cases have common roots and namely internal imbalances: large
budget deficits.
 Currency board is associated with policies aimed at achieving macroeconomic
stabilization and in the case of the present developments in Bulgaria with the
inflationary recession. It is introduced when other possible approaches as price,
wage and money supply controls are seen as not credible. It is a very harsh
institutional arrangement to stabilize the national currency since the government
has no room for flexibility if policy adjustments are needed.
Is currency board a solution?
 The discussion in the previous sections shows that the Bulgarian economic policy makers are
obviously on a crossroad. Some of them see currency board is a kind of panacea for the troubled
Bulgarian economy. Just to mention here the statement of the former advisor to the socialist
governments I. Angelov that the introduction of the currency board "is the only possibility to stop the
economic collapse" (Sega, No.4, 30 Jan-5 February 1997, pp.30-32, p.30). Is it really?
 My answer is: I doubt it. In the following I am briefly explaining why. Currency board is in principle an
exchange rate approach to combat inflation. It presupposes something which is rarely given: there
must be absolutely no difference between the domestic rate of price increase and that of the
country (or countries) which currency (or basket of currencies) serve (s) as the key
currency/currencies. In May 1997 it was announced that the D Mark will serve as an anchor
currency and this arrangement was made as of 1 July 1997 . If there is a price increase differential,
and in the Bulgarian case this is unavoidable given the collapse of the economy, the consequence
is something which might be called a repressed depreciation , since the exchange rate is fixed. The
consequences are numerous, but I would point here the following four:
1. The Bulgarian Lev will appreciate in real terms with the negative impact on the country's export and
competitiveness.
2. The trade balance and the current account will deteriorate.
3. Balance of payments financing will be urgently needed, thus deteriorating further the external
balance.
4. Real incomes will decline, given the downward pressure on the value of the currency.