What is a currency board?

The currency board system that was initially created to connect distant colonies to the monetary system of their mother countries still serves today after several modifications as the foundation of the monetary policy of several countries and regions. Global financial integration and technological development have fostered the use of better alternatives of independent monetary policy at ensuring the price stability also in smaller economies. Estonia has applied the currency board arrangement since 1992.

Currency board-based monetary policy is the most direct and transparent way of pegging a local currency to the currency of the state which has a predominant role in the monetary policy sense. Although theoreticians have accused currency boards of excessive rigidity also in comparison to the so-called conventional fixed exchange rate policies, Estonia's and other countries' experience where the currency board system is used, show that if distinct institutional prerequisites are met, it is possible to be sufficiently flexible without sacrificing reliability. Moreover, recent history shows that countries with the currency board-based monetary policy, if they support economic development and strive to avoid financial crises, have coped even more successfully than countries applying different monetary systems.

Despite the great diversity of the modern currency board-based systems, they generally have three common features:

1. the exchange rate is pegged to the anchor currency;
2. currency board liabilities - cash and deposits - are fully covered by the interest-bearing and high quality foreign currency reserves;
3. currency is fully convertible for current account as well as capital account transactions.

Estonian monetary acts stipulate that the kroon exchange rate is pegged to the euro (earlier it was the German mark) and prescribe that all cash put into circulation by Eesti Pank must be guaranteed by hard currency reserves. The Estonian currency board is not a separate institution but functions as part of Eesti Pank's operations. Thus, not only the base money has to be guaranteed by hard currency reserves but also all Eesti Pank's liabilities and issued collaterals.

Within the framework of modern currency boards it is possible to resort to various approaches and means when conducting monetary policy operations. As a rule, central banks use monetary policy instruments to influence short-term interest rates at the inter-bank money market, which in turn is aimed at achieving some interim goal (exchange rate (the price of one currency as expressed in another currency), money supply (the amount of money in the economy), long-term interest rates) or immediately the ultimate goal of the monetary policy - price stability. These central banks that target the exchange rate stability sometimes practice direct interventions at the foreign exchange market in order to pursue suitable exchange rate while maintaining the stability of interest rates.

Also modern currency boards may adopt different approaches. For example, Eesti Pank uses direct participation in the foreign exchange market to maintain the exchange rate. This means in reality that the so-called technical exchange rate deviations are precluded and no preconditions are set as to the development level and the depth of the domestic market. In Hong Kong where only cash conversion is guaranteed by the currency board-based system, exchange rates are balanced mainly through interest arbitration (utilisation of interest rate spread). However, during recent financial disruptions the Hong Kong dollar was successfully protected by the central bank's intervention on the foreign exchange market when the extremely high interest level started to shake the investors and business partners trust in the viability of local companies.