Currency boards

Currency board exists when a country’s central bank commits to back its monetary base—its money supply—entirely with foreign reserves at all times.This commitment means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first.Eight countries or regions, including Hong Kong Special Administrative Region of China, utilize currency boards as a means of fixing their exchange rates.

Argentina.In 1991, Argentina moved from its previous managed exchange rate of the Argentine peso to a currency board structure.The currency board structure fixed the Argentine peso’s value to the US dollar on a one-to-one basis.The Argentine government preserved the fixed rate of exchange by requiring that every peso issued through the Argentine banking system be backed by either gold or US dollars held on account in banks in Argentina.This 100％ reserve system made the monetary policy of Argentina dependent on the country’s ability to obtain US dollars through trade or investment.Only after Argentina had earned these dollars through trade could its money supply be expanded.This requirement eliminated the possibility of the nation’s money supply growing too rapidly and causing inflation.

An additional feature of the Argentine currency board system was the ability of all Argentines or foreigners to hold dollar-denominated accounts in Argentine banks.

These accounts were in actuality Eurodollar accounts—dollar-denominated deposits in non-US banks.These accounts provided savers and investors with the ability to choose whether to hold pesos.

From the very beginning, however, there was substantial doubt in the market that the Argentine government could maintain the fixed exchange rate.Argentine banks regularly paid slightly higher interest rates on peso-denominated accounts than on dollar-denominated accounts.This interest differential represented market-determined risk premium of the system itself.Depositors were rewarded for accepting risk—for keeping their money in peso- denominated accounts.This was an explicit signal by the marketplace that there was a perceived possibility that what was then “fixed” would not always be so.

The market proved to be correct.In January 2002, after months of economic and political turmoil and nearly three years of economic recession, the Argentine currency board was ended.The peso was first devalued from Peso1.00/$ to Peso1.40/$, then floated completely.It fell in value dramatically within days.The Argentine decade-long experiment with a rigidly fixed exchange rate was over.The devaluation followed months of turmoil, including continuing bank holidays and riots in the streets of Buenos Aires.