A nation that manages its currency via a currency board (for example, Estonia and Latvia) has to have sufficient foreign reserves to match the outstanding central bank liabilities (reserves and cash outstanding). Under this arrangement it can always guarantee 100 per cent convertibility but has to endure deflationary tendencies unless it runs external surpluses.
Answer: True
The answer is True.
In a currency board system, the central bank only creates liabilities (reserves, currency or loans) if it has gold or foreign currency reserves to match.
The other characteristics is that the central bank pegs the national currency at a fixed rate to some other foreign currency (or currencies if a basket is used). In this way, the central bank guarantees that there is 100 per cent convertibility of its own currency into the currency that it is pegged against given that the local currency is fully backed by reserves in the other currency.
The currency board proponents argue that by maintaining currency convertibility and a fixed exchange rate it generates confidence in the local currency which they argue stabilises the economy.
The central bank stands by to guarantee this convertibility at a pegged exchange rate against the so-called anchor currency. So this part of the proposition outlined in the question is true.
Currency board systems also typically ban the central bank from lending to the treasury which forces government to fully fund its fiscal policy spending from the private bond markets.
A further characteristic which is often implemented is that the central bank does not try to manage reserves and thus allows the overnight interest rate and the term structure (the longer rates on the yield curve) to be purely market-determined. But if banks face a squeeze on their reserves (in the domestic currency) then the only way this can be resolved is for interest rates to rise to attract the funds.
All these characteristics are present in the Estonian case.
As an aside: a pure currency board arrangement involves the creation of a separate institute (called the "currency board") which is independent of government (particularly the central bank). Its sole function is to provide foreign reserves to match the central bank liabilities. Modern currency boards, however, blur this distinction and allow the central bank to serve both functions.
Estonia pegs its currency at 15.60 krooni per Euro (after joining the European Exchange Rate (ERM) system in June 2004. Latvia pegs its currency at 0.71 lat per Euro and joined the ERM in 2005. Estonia initially pegged against the German mark when the Soviet system collapsed and they abandoned the rouble. Latvia switched their currency anchor from the IMF Special Drawing Rights bask to the Euro on January 1, 2005.
So Estonia and Latvia are both running currency systems similar to Argentina in the 1990s which ultimately collapsed and led to its default in 2001 (Argentina pegged against the US dollar).
A currency board thus requires that a nation always have sufficient foreign reserves to ensure at least 100 per cent convertibility of the monetary base (reserves and cash outstanding).
And most importantly it forces the treasury to run tight fiscal policy because it is always subject to the discipline of the private domestic bond markets.
The currency board arrangement in Estonia only guarantees 100 per cent convertibility of the monetary base. So it does not cover the broader monetary expansion that the banks generate by lending. In this context, there are problems when a financial panic occurs which leads to a bank run. If the depositors try to convert their demand deposits into the reserve currency the banks have a problem.
They can use their own store of foreign currency reserves or borrow the currency in international markets. But both these options are short-term at best and when exhausted the crisis becomes critical. The problem stems from the fact that the central bank does not pay a lender of last resort role to the commercial banks in this system.
Now has does external trade impact on a nation running a currency board - which addresses the second part of the question?
A nation running a currency board can only issue local currency in proportion with the foreign currency it holds in store (at the fixed parity). If such a nation runs an external surplus, then reserve deposits of foreign currency rise and the central bank can then expand the monetary base.
Currency board nations are heavily dependent on successful export-led growth strategies with suppressed domestic (private and public) consumption.
A nation running a currency board can run external deficits (on the current account) for a time as long as their are sufficient foreign reserves so that the central bank does not need to contract the monetary base (its liabilities). In particular, if investment is targeted at productive ventures building extra export capacity and if the nation has enough foreign reserves then a current account deficit for a time can be beneficial in the longer term.
But persistent current account deficits become particularly problematic for a nation running a currency board. The nation faces the continual drain of its foreign reserves which has two impacts. First, the peg comes under pressure. Second, the central bank has to contract the monetary base (its liabilities) which has a negative impact on aggregate demand
With an external deficit, the monetary base has to contract (so no sterilisation of the reserve outflow) which forces up interest rates because there is a dearth of bank reserves to keep the payments system running. While the higher rates may attract foreign capital inflow they are also deflationary. Proponents of this arrangement argue that the deflation starts a process of internal devaluation (wages and prices fall) and increase the competitiveness of the export sector. So exactly what the EMU want Ireland and Greece etc to do.
But it is clear that currency board arrangements, which eliminate the capacity of the central bank to run discretionary monetary policy, lead to pro-cyclical policy outcomes. So in boom times, with exports strong, the monetary base expands and interest rates fall. So monetary policy reinforces the demand boom.
But if exports fall and thus aggregate demand weakens and/or foreign capital outflow occurs then the monetary base contracts and interest rates rise therefore causing a further contraction. Moreover, when times are bad, the treasury may not be able to fund its current budget position (if in deficit) and so fiscal policy has to contract which worsens the situation.
Currency boards collapse when there is a major collapse in export growth and hence a loss of capacity to build foreign currency reserves and support local demand.
The problem is that in those cases a crisis quickly follows because the economy has engineer a sharp domestic contraction to reduce imports but also runs out of reserves and has to default on foreign currency debt (either public or private). It is a recipe for disaster.
Overall, the answer is true.
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