Central banking is familiar to most people, at least on a practical level, as the monetary system of their country. A central bank is a monetary authority that has discretionary monopoly control of the supply of the reserves of commercial banks. Usually this implies a monopoly of the supply of notes (paper currency) and coins.[1] Discretionary control means the ability to choose a monetary policy at will, at least partly unconstrained by rules. Reserves mean the medium used to settle payments. Often, a monetary system uses two types of media to settle payments: one type that is used primarily domestically, such as notes issued by the monetary authority, and foreign reserves (ultimate reserves) used in international trade, such as gold, foreign bonds, or notes issued by a foreign central bank. Commercial banks, in the broad sense that we will use the term, are all banks other than the central bank, including cooperative banks, investment banks, and savings banks.

Though the currency board system has enjoyed a revival of interest, it remains imperfectly known to many people. A currency board is a monetary institution that issues notes and coins (and, in some cases, deposits) fully backed by a foreign “reserve” currency and fully convertible into the reserve currency at a fixed rate and on demand. The reserve currency is a convertible foreign currency or a commodity chosen for its expected stability. The country that issues the reserve currency is called the reserve country. (If the reserve currency is a commodity, the country that has the currency board is itself considered the reserve country.)

As reserves, a currency board holds low-risk, interest-earning securities and other assets payable in the reserve currency. A currency board holds reserves equal to 100 per cent or slightly more of its notes and coins in circulation, as set by law. The simplest type of currency board accepts no deposits and issues no securities; if a currency board does accept deposits or issue securities, they too must be backed 100 per cent or slightly more by assets payable in the reserve currency. A currency board earns profits from the difference between the return on the reserve-currency securities it holds and the expense of maintaining its notes and coins in circulation. It remits to the government (or to its owner, if not the government) profits beyond what it needs to pay its expenses and to maintain its reserves at the level set by law. A currency board does not have discretionary control of the quantity of notes, coins, and deposits it supplies. Market forces determine the quantity of notes, coins, and deposits it supplies, and hence the overall money supply in a currency board system.

A currency board is only a part of the monetary system in any country that has commercial banks and other financial institutions. The currency board system commercial banks and other financial institutions. The currency board system comprises the currency board, commercial banks, and other financial institutions. It also comprises certain rules of behavior by them and the government concerning exchange rates, convertibility, government finance, and so on.

Table 1 lists differences between a typical currency board and a typical central bank. This section briefly explains each difference. Later chapters discuss the differences in detail. We emphasize that the descriptions are accurate for typical actual currency boards and central banks, past and present. The description of a currency board does not describe a theoretically ideal currency board, nor does it describe an exceptionally good actual currency board. It describes atypical actual currency board, although the actual performance of currency boards has been close to the ideal they have been established to strive for (see chapter 3). Similarly, the description of a central bank does not describe a theoretically ideal central bank. Nor does it describe an exceptionally good actual central bank such as the U.S. Federal Reserve System or the Monetary Authority of Singapore. It describes a typical actual central bank. The description fits most central banks, especially those in developing countries, which are a substantial majority of central banks in existence today.

Tablo 1. A typical currency board versus a typical central bank

Typical currency board	Typical central bank
Usually supplies notes and coins only	Supplies notes, coins, and deposits
Fixed exchange rate with reserve currency	Pegged or floating exchange rate
Foreign reserves of 100 per cent	Variable foreign reserves
Full convertibility	Limited convertibility
Rule-bound monetary policy	Discretionary monetary policy
Not a lender of last resort	Lender of last resort
Does not regulate commercial banks	Often regulates commercial banks
Transparent	Opaque
Protected from political pressure	Politicized
High credibility	Low credibility
Earns seigniorage only from interest	Earns seigniorage from interest and inflation
Cannot create inflation	Can create inflation
Cannot finance spending by domestic government	Can finance spending by domestic government
Requires no “preconditions” for monetary	Requires “preconditions” for monetary reform
Rapid monetary reform	Slow monetary reform
Small staff	Large staff

 

To begin at the top of the list in Table 1, a typical currency board usually supplies notes and coins only, whereas a typical central bank also supplies deposits. Some past currency boards have accepted deposits; today, the Hong Kong Monetary Authority and some currency board-like monetary authorities issue securities. The deposits of a typical currency board are subject to the same foreign reserve requirement as its notes and coins. To simplify exposition of the currency board system, this study usually discusses currency boards as if they issue notes and coins only. The additional complications that result from deposits and securities are minor and do not significantly change the analysis if they are interchangeable for their holders and subject to a uniform foreign reserve requirement for the currency board.

Notes and coins issued by the currency board or central bank and deposits of commercial banks at the currency board or central bank constitute the monetary base. The monetary base counts as reserves when held by commercial banks, but not when held by the public. Deposits of the public at commercial banks and notes and coins held by the public constitute the money supply.[2] Notes and coins in circulation, whether held by the public or by commercial banks, constitute cash.

Deposits at the central bank are the main form of reserves for commercial banks in a typical central banking system. In a typical currency board system, commercial banks hold no deposits at the currency board; instead, reserve-currency assets are their main form of reserves. In a currency board system and a central banking system alike, commercial banks hold “vault cash”–notes and coins of the currency board or central bank–to satisfy their depositors’ requests to convert deposits into notes and coins.

A typical currency board maintains a truly fixed exchange rate with the reserve currency. The exchange rate is permanent, or at most can be altered only in emergencies. The exchange rate may be written into the constitution that describes the legal obligations of the currency board. The record of currency boards in maintaining fixed exchange rates has been excellent (see chapter 3). A typical central bank, in contrast, maintains a pegged or floating exchange rate rather than a truly fixed rate. A pegged exchange rate is constant for the time being in terms of a reserve currency, but carries no credible long-term guarantee of remaining at its current rate. A floating exchange rate is not maintained constant in terms of any reserve currency. The exchange rate maintained by a central bank is typically not written into law, and can be altered at the will of the central bank or the government. When a typical central bank suffers heavy political or speculative pressure to devalue the currency, it devalues. As we shall see later, allegedly fixed exchange rates maintained by central banks have in reality typically been pegged exchange rates.

As reserve assets against its liabilities (its notes and coins in circulation), a typical currency board holds securities in the reserve currency; it may also hold bank deposits and a small amount of notes in the reserve currency. It holds foreign reserves of 100 per cent or slightly more of its note, coin, and deposit liabilities, as set by law. Many currency boards have held a maximum of 105 or 110 per cent foreign reserves to have a margin of protection in case the reserve-currency securities they held lost value. A typical central bank, in contrast, has variable foreign reserves: it is not required to maintain any fixed, binding ratio of foreign reserves to liabilities. Even where a minimum ratio exists, a typical central bank can hold any ratio in excess of that. For example, a central bank required to hold at least 20 per cent foreign reserves may hold 30, 130, or even 330 per cent foreign reserves. A typical central bank also holds domestic-currency assets, which a typical currency board does not.

A typical currency board has full convertibility of its currency: it exchanges its notes and coins for reserve currency at its stated fixed exchange rate without limit. Anybody who has reserve currency can exchange it for currency board notes and coins at the fixed rate, and anybody who has currency board notes and coins can exchange them for reserve currency at the fixed rate. However, a currency board does not guarantee that deposits at commercial banks are convertible into currency board notes and coins. Commercial banks are responsible for holding enough notes and coins as vault cash to satisfy their contractual obligations to their depositors to convert deposits into notes and coins on demand. If the government imposes no minimum reserve requirement on commercial banks, commercial banks may hold any quantity (or ratio of reserves to liabilities) that they think is prudent; they are not required to hold 100 per cent foreign reserves like the currency board, nor 100 per cent currency board notes and coins against deposits. (In other words, M0 is backed 100 per cent by foreign reserves in a currency board system, but broader measures of the money supply such as M1, M2, and M3 are not.) Deposits at commercial banks denominated in the currency board currency are fully convertible at a fixed exchange rate into currency board notes and coins, and currency board notes and coins are fully convertible at a fixed exchange rate into the reserve currency. As for foreign currencies other than the reserve currency, the currency board has no direct role in determining exchange rates with them. Commercial banks trade them at market-determined exchange rates, which may be fixed, pegged, or floating against the reserve currency and hence against the currency board currency.

A typical central bank, in contrast, has limited convertibility of its currency. Central banks in almost all developed countries and in some developing countries have fully convertible currencies, but most central banks in developing countries have partly convertible or inconvertible currencies. They restrict or forbid certain transactions, particularly purchases of foreign securities or real estate (see the International Monetary Fund’s Annual Report on Exchange Arrangements and Exchange Restrictions).

A typical currency board has a rule-bound monetary policy. A currency board is not allowed to alter the exchange rate, except perhaps in emergencies. Nor is a currency board allowed to alter its reserve ratio or the regulations affecting commercial banks. A currency board merely exchanges its notes and coins for reserve currency at a fixed rate in such quantities as commercial banks and the public demand. When the demand for money changes, the role of a currency board is passive. Market forces alone determine the money supply through a self-adjusting process described in chapter 3.

A typical central bank, in contrast, has a partly or completely discretionary monetary policy. A central bank can alter at will, or with the approval of the government, the exchange rate, its ratio of foreign reserves, or the regulations affecting commercial banks. It is not subject to strict rules like a typical currency board.

A typical currency board is not a lender of last resort, that is, it does not lend to commercial banks or other firms to help them avoid bankruptcy. Commercial banks in a currency board system must rely on alternatives to a lender of last resort (see chapter 6). A typical central bank, in contrast, is a lender of last resort.

A typical currency board does not regulate commercial banks. Banking regulations in a currency board system are usually few, and are enforced by the ministry of finance or an office of bank regulation. A typical central bank, in contrast, often regulates commercial banks. Perhaps the most common form of regulation is imposing reserve requirements on commercial banks. The required reserves, which are held in the form of deposits at the central bank and vault cash, typically exceed the prudential reserves that commercial banks would hold if no reserve requirements existed.

The activities of a typical currency board are transparent, because a currency board is a very simple institution. It is merely a sort of warehouse for reserve-currency securities that back its notes and coins in circulation. The activities of a typical central bank are opaque. A central bank is not a warehouse; it is a speculating institution whose effectiveness partly depends on the ability to act secretly sometimes.[3]

Because a typical currency board is rule-bound and transparent, it is protected from political pressure. It is protected by implicit rules of political behavior, or, better yet, by an explicit constitution such as that of the Appendix. A typical central bank is politicized. Some central banks, such as the U.S. Federal Reserve System and the European Central Bank, are politically independent in the sense that their governors, once appointed, have sole control of the monetary base and cannot be fired by the executive branch of the government or the legislature during their fixed terms of office, and that the executive branch or legislature cannot dictate lending by the central bank. Even the most politically independent central banks sometimes yield to strong political Even the most politically independent central banks sometimes yield to strong political pressure, though.

A typical currency board has high credibility. Its 100 per cent foreign reserve requirement, rule-bound monetary policy, transparency, and protection from political pressure enable it to maintain full convertibility and a fixed exchange rate with the reserve currency. An appropriately chosen reserve currency will be stable; therefore, the currency issued by the currency board will be stable. A typical central bank, in contrast, has low credibility. A few exceptionally good central banks, which exist mainly in developed countries, have high credibility, but the majority do not. Because a typical central bank has discretion in monetary policy, is opaque, and is politicized, it has the means and the incentive to break promises about the exchange rate or inflation whenever it wishes.

Readers may ask how credible a typical currency board can be if, as has been the case with most currency boards, its reserve currency is issued by a central bank. Might not the central bank of the reserve country create monetary instability in a country with a currency board, for example? No central bank has a perfect record of combating inflation. The central bank of the reserve country may export instability and inflation to the currency board country through the currency board.

We reply that one must think in terms of relative credibility. The reserve currency, if a currency issued by a central bank rather than a commodity, should be issued by an exceptionally good central bank, such as the U.S. Federal Reserve System, European Central Bank,[4] or Bank of Japan. Those three central banks are not perfect, but they have much more credibility than most other central banks now have or will have in the foreseeable future. The U.S. dollar, the euro, and the Japanese yen have exceptionally good records and good prospects for future stability, whereas most currencies issued by other central banks have bad records and bad prospects for future stability. For example, among developing countries with more than 1 million people, 90 percent had their currencies depreciate against the dollar from 1970 to 1993 (Schuler 1996: 33). A currency board transmits the relative credibility of the reserve country’s central bank to the currency board country, whereas no such effect occurs if the country continues with a typical central bank. A currency board can “import” the monetary policy of an exceptionally good central bank by means of a fixed exchange rate to the currency issued by that central bank.

A typical currency board earns seigniorage (income from issue) only from interest. The currency board earns interest from its holdings of reserve-currency securities (its main assets), yet pays no interest on its notes and coins (its liabilities). Gross seigniorage is the income from issuing notes and coins. It can be explicit interest income or implicit income in the form of goods acquired by spending money. Net seigniorage (profit) is gross seigniorage minus the cost of putting and maintaining notes and coins in circulation.

A typical central bank also earns interest on its holdings of securities, which include domestic as well as foreign securities. It earns seigniorage on its notes and coins in circulation and on the deposits that commercial banks hold with it. The deposits, like notes and coins, usually pay no interest. But a more important source of seigniorage for a typical central bank is inflation. To define inflation precisely, it is a general increase in nominal prices, typically caused by an increase in the nominal money supply that is not the result of increased voluntary saving. A typical currency board cannot create inflation because it does not control the ultimate reserves of the monetary system. For instance, the currency board system of Hong Kong uses the U.S. dollar as its reserve currency. The ultimate reserves of the Hong Kong currency board system are the U.S. dollar monetary base, which is supplied by the U.S. Federal Reserve System rather than by the Hong Kong Monetary Authority. Like any system of fixed exchange rates, a currency board system may transmit inflation from the reserve country, but a currency board cannot create inflation because it cannot increase the monetary base independently of the monetary authority of the reserve country. A typical central bank, in contrast, can create inflation at its discretion by increasing the domestic monetary base.

A typical currency board cannot finance spending by the domestic government or domestic state enterprises because it is not allowed to lend to them. A typical central bank finances spending by the domestic government, whether to a relatively small extent (as in the United States) or to a large extent (as in many developing countries today).

A typical currency board requires no “preconditions” for monetary reform. Contrary to claims that have been made by studies from the International Monetary Fund (Baliño, et al., 1997: 18; Enoch & Gulde 1997: 26-7), government finances, state enterprises, or trade need not be already reformed before the currency board can begin to issue a sound currency (Hanke, 1999). A typical central bank cannot issue a sound currency unless the “fiscal precondition” exists, that is, the government no longer needs to finance budget deficits by means of inflation. Once governments start to depend on central banks for financing deficits, they usually have trouble stopping.

A typical currency board is conducive to rapid monetary reform. It can be established quickly and fulfill its purpose quickly. A typical central bank is a hindrance to rapid monetary reform.

Finally, a typical currency board needs only a small staff of a few persons who perform routine functions that are easily learned. A typical central bank needs a large staff trained in the intricacies of monetary theory and policy. The People’s Bank of China employs 150,000 people; the Central Bank of the Russian Federation, more than 90,000; and the German Bundesbank and the Bank of France about 16,000 each (Hanke, 2000).

notes

[1] In some countries, a government agency other than the central bank issues coins. Coins are typically a very small proportion of the total money supply, and the agency issuing coins usually coordinates its policy with that of the central bank, so it typically has no independent influence on monetary policy.

[2] We make this definition of the money supply for ease of exposition. In practice, near-monies such as accounts at money market mutual funds may be almost as liquid and widely accepted in payment as deposits at commercial banks. To avoid such problems of definition, one can think of commercial banks as symbolizing all institutions that extend credit widely accepted as means of payment.

[3] Even the most respected central banks have hidden their activities from public inspection. For example, the economist Oskar Morgenstern (1963: 20-1), who researched the accuracy of central bank balance sheets, remarked that Central banks in many countries, the venerable Bank of England not excepted, have for decades published deliberately misleading statistics, as, for example, when part of the gold in their possession is put under “other assets” and only part is shown as “gold.” In democratic Great Britain before World War II, the Government’s “Exchange Equalization Account” suppressed for a considerable period all statistics about its gold holdings, although it became clear later that these exceeded the amount of gold shown to be held by the Bank of England at the time. This list could be greatly lengthened. If respectable governments falsify information for policy purposes, if the Bank of England lies and hides or falsifies data, then how can one expect minor operators in the financial world always to be truthful, especially when they know that the Bank of England and so many other central banks are not?

[4] When we first wrote this passage in 1994, it mentioned the German Bundesbank. We revised it in 2000 to reflect that the European Central Bank had begun issuing the euro in 1999. The euro has proved durable despite stresses.

References

Baliño, T., & Enoch, C. (1997). Currency board arrangements: Issues and experiences, International Monetary Fund Occasional Paper No.151. doi. 10.5089/9781557756688.084

Enoch, C., & Anne-Marie G. (1997). Making a currency board operational, International Monetary Fund Paper on Policy Analysis and Assessment 97/10, November.

Hanke, S.H. (1999). Some reflections on currency boards, in M.I. Blejer & M. Skreb (eds) Central Banking, Monetary Policies, and the Implications for Transition Economies: 341-66. Norwell, Massachusetts: Kluwer Academic Publishers.

IMF, (annual). International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, Washington: International Monetary Fund.

Hanke, S.H. (2000). Parkinson in Euroland, Forbes Global, April 3: 24.

Morgenstern, O. (1963). On the Accuracy of Economic Observations, 2nd ed., Princeton: Princeton University Press.

Schuler, K. (1996). Should Developing Countries Have Central Banks? Currency Quality and Monetary Systems in 155 Countries, Research Monograph 52. London: Institute of Economic Affairs.