The Currency Board
Aside from the complete adoption of another and more credible currency, such as the US dollar, the hardest form of currency peg is the currency board. Here, the central bank relinquishes theoretically all discretion over monetary policy. Capital inflows lead automatically to a proportional reduction in money supply by the “monetary authority”, which replaces the job of the central bank, and vice versa. The monetary authority pledges to exchange the domestic currency for the peg currency, usually the US dollar, at the peg rate in any size. Needless to say, this means it has to have the foreign exchange reserves in order to be able to do so. This in turn has real impact on the economy. For a start, there has to be a strong degree of domestic price flexibility in order to ensure that domestic prices are able to adjust to changes in the economy since the external price — the exchange rate — cannot adjust because of its peg/currency board constraint.
Currency boards are no panacea. They imply and impose a very harsh policy discipline.
A country has to be willing — and be seen to be willing — whatever economic pain is required in order to maintain the currency board. On the positive side, they should provide transparency and monetary credibility in addition to stability, which in turn should provide a medium-term foundation for growth, albeit at a cost. As the example of Argentina suggests, currency boards do not imply a guarantee of stability. They have tended however to be considerably more resistant to speculative attack than has been the case with the crawling peg, in large part because they have provided a greater degree of monetary credibility. Note that a currency board requires that the monetary authority’s foreign exchange reserves more than cover the monetary base. They do not and are not able to cover the broad money definition, which means that they remain vulnerable in theory, particularly if locals abandon their own currency.