The Cayman Islands and Hong Kong are two of the world’s great financial centers. They both owe a great deal of their success to the fact that they employ currency boards. Their currency boards allow them to issue the Cayman and Hong Kong dollars. Both of these domestic currencies are, in fact, clones of the mighty U.S. dollar—the world’s dominant international currency.
Currency boards have existed in over 70 countries. The first one was installed in the British Indian Ocean colony of Mauritius in 1849. By the 1930s, currency boards were widespread among the British colonies in Africa, Asia, the Caribbean, and the Pacific islands. They have also existed in a number of independent countries and city-states, such as Danzig and Singapore. One of the more interesting currency boards was installed in North Russia on Nov. 11, 1918, during the civil war. Its architect was none other than John Maynard Keynes, a British Treasury official responsible for war finance at the time.
Countries that have employed currency boards have delivered lower inflation rates, smaller fiscal deficits, lower debt levels relative to their gross domestic product, fewer banking crises, and higher real growth rates than comparable countries that have employed central banks.
So, just what is a currency board? An orthodox currency board issues notes and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. As reserves, it holds low-risk, interest-bearing bonds denominated in the anchor currency and typically some gold. The reserve levels (both floors and ceilings) are set by law and are typically kept between 100 and 120 percent of its monetary liabilities (notes, coins, and, if permitted, deposits). A currency board’s convertibility and foreign reserve cover requirements do not extend to deposits at commercial banks or to any other financial assets. A currency board generates profits (seigniorage) from the difference between the interest it earns on its reserve assets and the expense of maintaining its liabilities.
By design, a currency board has no discretionary monetary powers and cannot engage in the fiduciary issue of money. It has an exchange rate policy (the exchange rate is fixed) but no monetary policy. A currency board’s operations are passive and automatic. The sole function of a currency board is to exchange the domestic currency it issues for an anchor currency at a fixed rate. Consequently, the quantity of domestic currency in circulation is determined solely by market forces, namely the demand for domestic currency. Since the domestic currency issued via a currency board is a clone of its anchor currency, a currency board country is part of an anchor currency country’s unified currency area.
A timeline of the major events in the evolution away from the use of a foreign currency to the issue of the Cayman dollar via a currency board that has become more orthodox over time is presented in Figure 1. See figure 1
Before the establishment of its currency board, the Cayman Islands used the Jamaican currency, which remained the only legal tender, even after Jamaica abandoned its currency board and became independent in 1962. Concerned about the stability of the Jamaican currency, Caymanians eventually realized that it would be necessary to introduce their own separate currency.
In September 1970, the United Kingdom granted the Cayman Islands formal permission for the issue of a new, independent currency. The Currency Law of 1971, which was formally approved in October of that year, led to the formation of the Cayman Islands Currency Board. Initially, the Cayman dollar was anchored to the British pound. In a quest for more stability, the Cayman dollar’s anchor was changed from the British pound to the U.S. dollar under the Currency Law of 1974. This illustrates the fact that, with a currency board, a country might have no (or little) discretionary monetary policy, but it has monetary sovereignty. It also illustrates, once again, the high priority the Cayman Islands have placed on currency stability.
Following Euromoney Magazine’s designation of the Cayman Islands as an offshore financial center, the Monetary Authority Law of 1996 replaced the Cayman Islands Currency Board with the Cayman Islands Monetary Authority (CIMA). The Cayman Islands Monetary Authority took over the responsibilities of the Currency Board in addition to the responsibilities of the Financial Services Supervision Department.
As the monetary authority of one of the world’s most important financial centers, CIMA devotes the majority of its staff to financial regulation. Today, its monetary functions are handled solely by its Currency Operations division (the currency board), which, as of Dec. 31, 2017, consists of only seven staff members. On the other hand, the Authority’s regulatory functions are handled by its Banking Supervision, Fiduciary Services, Insurance Supervision, Investments Supervision, and Securities Supervision divisions, which together, as of Dec. 31, 2017, have 109 employees.1 The Cayman Islands, therefore, illustrates an important feature of currency boards: unlike central banks, currency boards require tiny staffs. Indeed, only seven staff members man the Cayman’s currency board operations.
Now, let’s turn to the evolution of the currency system in the Cayman Islands. In a move towards orthodoxy, section 32 of the Monetary Authority Law of 1996 mandates that external assets should not fall below 90 percent of the demand liabilities (monetary base) of the Authority. This means that net foreign assets as a percentage of the monetary base should always be 90 percent or above, which represents a stricter limit than had existed under the currency laws of the 1970s. The following analysis indicates that the currency board operations have become more orthodox over time.
Figure 2 shows net foreign reserves as a percentage of the monetary base from 1972 through 2017. The vertical line marks the end of the Cayman Islands Currency Board and its replacement by the Cayman Islands Monetary Authority in 1997. Orthodox currency boards typically have net foreign reserves between 100 and 120 percent of their monetary base.
During the period of operation under the Cayman Islands Currency Board from 1972 to 1996, the ratio of net foreign reserves to monetary base ranged between 58 and 115 percent and averaged 92 percent. After the transition to the Cayman Islands Monetary Authority, the ratio was much higher and tighter, ranging from 115 to 134 percent and averaging 124 percent. The Monetary Authority Law of 1996 made currency board operations much more orthodox.
The move to orthodoxy, with the introduction of the CIMA, is also on display in Figure 3, which compares the percentage changes in monetary base and in net foreign reserves. The correlation coefficient between the two metrics increases from 0.6209 to 0.8562 after the transition to the CIMA. This indicates much less monetary discretion.
The Cayman Islands currency story is one of stability. Indeed, the Cayman Islands realizes that, when it comes to currency, stability might not be everything, but everything is nothing without stability. After Jamaica abandoned its currency board, the Caymans rightfully anticipated that the Jamaican dollar would become a third-rate Caribbean currency. In consequence, the Caymans dumped the Jamaican dollar and replaced it with a Cayman dollar issued by a currency board in 1972. Shortly thereafter, Cayman realized that the British pound, which was the anchor for the original Cayman dollar, was unstable. So, in 1974, the anchor was changed from the British pound to the U.S. dollar. Finally, after the Cayman Islands became recognized as an offshore financial center, today’s Cayman Islands Monetary Authority took over the currency board operations in 1997. With that, the currency board operations became even more orthodox. In consequence, stability has become more deeply entrenched. This allowed the Cayman Islands to weather the global financial crisis of 2008 largely unaffected.2
1 Cayman Islands Monetary Authority Annual Report, 2017, pp. 12-13.
2 Anthony Travers, “An Open Letter to President Obama from the Cayman Islands Financial Services Association,” May 5, 2009.