The Stability of currency boards

ENCurrency boards have a long and intriguing history as monetary and exchange rate arrangements in many parts of the world. They have repeatedly gone out of fashion, just to resurface again a while later. The latest wave of currency board introduction started in the last decade of the twentieth century, when Argentina pegged its peso to the US dollar in 1991, to end a long period of rampant hyperinflation. The Argentinean currency board was soon followed by corresponding institution in Estonia (1992), Lithuania (1994), Bulgaria, and Bosnia (both 1997), where political and economic transformation posed enormous challenges to economic and monetary policy. Currency boards assume a prominent position in the ongoing discussion about the merits of fixed versus flexible exchange rates, especially considering the prevalent notion that countries should either opt for truly flexible or truly fixed exchange rates, but avoid the middle ground. In this context, currency boards present the most rigidly fixed exchange rate arrangement short of a monetary union, yet they allow a country to retain its domestic currency. However, not only since the Argentinean debt default in 2001 and the ensuing abandonment of the currency board have economists been aware of and have discussed the stability and the inherent risks of adopting a currency board.This thesis examines in great details the stabilizing effects resulting from the introduction of a currency board, and demonstrates how its design features, as well as the economic environment it operates in affect its long-term sustainability. The author shows that short-term stabilization, e.g. after hyperinflation, can almost always be achieved by means of a currency board; the barriers to exit have just to be set high enough. The countries to benefit most from currency board introduction are those, where the political as well as economic environment tend to foster high inflation. However, this blessing derived from high barriers to exit may well turn into a curse when the combination of a currency board and a non-accommodative economic environment lead to mounting real imbalances in the economy. The high barriers to exit lead policymakers to adhere to the currency board much longer than to a conventional fixed exchange rate, so that once the currency board is abancloned due to economic pressures, the exit is often accompanied by economic collapse, as was recently the case in Argentina. Therefore, to ensure the sustainability of a board, a number of preconditions have to be met, such as restrictive fiscal policy, flexible goods and labor markets, a robust financial sector, and the choice of an adequate anchor currency.