A currency board is a country’s monetary organization that works like a central bank with the aim of setting up a fixed exchange rate with another country. A currency board integrates three basics: a fixed exchange rate to a specific foreign currency, an automatic exchange using the fixed rate, and a sustainable commitment to the monetary structure.
Laws governing the operation of a currency board are set through the central bank policies. Countries implement a currency board with the aim of having a feasible anti-inflationary policy. This system can be implemented alone or integrated with the central bank; but having both monetary authorities is uncommon.
The specific foreign currency, also known as the “anchor currency”, is deemed to be a popular currency such as the U.S dollar and euro. In this sense, the value and constancy of the local currency depends on the value and constancy of the anchor currency.
This implies that a currency board strives to eliminate the central bank from its optional function of regulating money distribution and interest rates. A currency board structure can be effective if there are enough foreign exchange reserves within the capacity of the central bank, such that insufficient supply of funds might be covered.
Thus, there must be at least 100% of reserve currency and a sustainable pledge to the local currency by the currency board. Besides, a currency board does not hold funds that generate interests and thus it is not entirely considered a lender of last resort as in the case of a central bank.
Having a currency board as an exchange rate policy would lead to several economic advantages. Economic integrity, low inflation, and sustainable interest rates are the major good effects of this system to the new government of a small African nation. Since there is an official foreign exchange reserves, financial institutions and citizens can be assured that there is currency stability between domestic and foreign currency.
The demand for an anchored currency will be higher than that of unstable currencies since the interested parties know that their funds can be simply changed into an internationally-traded currency despite of factors that affect exchange rates.
Factors such as different monetary policies between countries are deemed to affect exchange rates. But with a currency board in place, a country is in, real sense, not in control of its monetary policy.
Good effects of currency board can be attributed to the countries that have successfully implemented the system. For instance, countries such as Argentina and Bulgaria have successfully implemented currency board in their economic policy.
Thus, the African nation in question should opt to peg the currency to the dollar with a currency board system because independent monetary policy for the small nation can be difficult to maintain.
Besides, currency board systems managed by various nations have faired well as compared to other fixed exchange rate policies. For instance, currency board within an economic system is deemed to reduce annual inflation by 3.5%; this is due to the higher demand of “currency board currency”.
The problems of currency board structures stem from the issues of currency stability. Having a currency board arrangement implies that a country might not have the capacity to structure a monetary policy that deals with other domestic aspects; a nation is restricted to operate inline with the agreements set by the foreign country. The fixed exchange rate is considered to set the country’s trade agreements, irrespective of economic disparities with its trading partners.
In addition, legal procedures may seem difficult to follow when there is need to back old currency issues. This is what happened to Indonesia in its bid to establish a currency board. A currency board often derives some laws from the central bank and it seems difficult to maintain both the currency board and the central bank. Sometimes partial backing might lead to difficulty in setting a constant pegged exchange rate policy.
Furthermore, the degree of uncertainty over the relevant value of the dollar might be a major problem. The African nation can underestimate the exchange rate value, leading to an unstable economy.
There is no genuine evidence that currency board is the better option for exchange rate because the regime has been successful in small nations and its application in bigger countries is still to be realized.
Lastly, if the currency board is established and the banking systems within the nation are weak, there would be some limitations. A currency board does not offer loans to banks and therefore it is not in a position to help such institutions when in crisis.
As a small African nation with few international ties, implementing a currency board as suitable exchange rate authority would be appropriate. This is because small countries such as Argentina have successfully implemented the system. However, the government should ensure that its banking systems are restructured to ensure economic stability.
Consensus should be established among the interested parties like the central banks, followed by careful planning and integration of essential legal and institutional changes.
Besides, the finance minister should opt to review the current monetary policy so as to establish effective financial strategies. As explained in the previous sections, currency board system will offer a stable-valued exchange rate that will lead to reduced inflation rate, economic integrity, and reduced interest rates.