What is a Currency Peg and Pegged Exchange Rate?

Currency Protection

The fixed exchange rate dynamic not only adds to a company’s earnings outlook, it also supports a rising standard of living and overall economic growth. But that’s not all. Governments that have sided with the idea of a fixed, or pegged, exchange rate are looking to protect their domestic economies. Foreign exchange swings have been known to adversely affect an economy and its growth outlook. And, by shielding the domestic currency from volatile swings, governments can reduce the likelihood of a currency crisis.

After a short couple of years with a semi-floated currency, China decided during the global financial crisis of 2008 to revert back to a fixed exchange rate regime. The decision helped the Chinese economy to emerge two years later relatively unscathed. Meanwhile, other global industrialized economies that didn’t have such a policy turned lower before rebounding.

Key Takeaways By pegging its currency, a country can gain comparative trading advantages while protecting its own economic interests. A pegged rate, or fixed exchange rate, can keep a country’s exchange rate low, helping with exports. Conversely, pegged rates can sometimes lead to higher long-term inflation. Maintaining a pegged exchange rate usually requires a large amount of capital reserves.

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OK, so why would a country peg its currency?

Here are some reasons:

  • It makes trade more predictable. If you rely heavily on exports — like a major oil producer does — then pegging your currency to another helps ensure neither you nor others have to worry about the exchange rate going up and down.
  • It helps countries with low costs of production keep exports cheap. Basically, when times are good, the peg keeps the currency artificially cheap.
  • To help address the problem of skyrocketing prices, which is called “hyperinflation.” A peg can bring back stability if the local currency is fixed to a relatively stable currency like the euro or the dollar.

But as we’ll learn, pegging means giving up a lot of control and can lead to its own problems.

But things can gowrong

There are several problems that countries can run into if their currency is pegged, including but not limited to:

  • Pegs mean a central bank loses control over some basic policy making. Interest rates in Hong Kong, for example, have to follow interest rates in the US, set by the Federal Reserve. It became a problem recently when the US was suffering through the great recession, but Hong Kong was enjoying a boom thanks to China’s growth. While the central bank would’ve liked to have seen higher interest rates to keep inflation down, it was forced to keep them low.
  • Central banks need to hold a lot of foreign currency to keep the peg going. Central banks need a huge amount of reserves to maintain the peg, but these reserves can also lead to higher inflation. And — as you’ll see below — when they run out of those reserves, chaos can ensue.
  • Pegging could incentivize the creation of a black market. An official peg may be something like 3 pesos for every dollar, but if there aren’t enough dollars, then you might find “unofficial” exchange rates on the street far different than the official peg. You might have to pay 6 pesos to get a dollar. That black-market price gives you a sense of what the exchange rate would be if the currency were not artificially fixed.

Example of a Fixed Exchange Rate

China switched from a fixed exchange rate in July 2005. It is now more flexible but still managed with a close eye. It prefers to keep its currency low to make its exports more competitive.

China's currency power comes from its exports to America. The exports are mostly consumer electronics, clothing, and machinery. In addition, many U.S.-based companies send raw materials to Chinese factories for cheap assembly. The finished goods become imports when they are shipped back to the United States.

Chinese companies receive American dollars as payment for their exports, which they deposit into their banks in exchange for yuan to pay their workers. Local Chinese banks transfer dollars to China’s central bank, which stockpiles them in its foreign currency reserves. The Chinese Central Bank holdings reduce the supply of dollars available for trade. That puts upward pressure on the dollar.

China's central bank also uses the dollars to purchase U.S. Treasurys. It needs to invest its dollar stockpile into something safe that also gives a return, and there's nothing safer than Treasurys. China knows this will further strengthen the dollar and lower the yuan's value.

Monitoring the Currency Peg

Since the US dollar also fluctuates, most countries usually peg their currencies to a dollar range as opposed to pegging to a practically fixed number. After pegging a currency, the central bank then monitors its value relative to the value of the US dollar. If the currency rises above or falls below the peg, the central bank would use its monetary tools, such as buying or selling treasuries in the secondary market, to restore the peg.

Example of a Currency Peg

Since 1986, the Saudi riyal has been pegged at a fixed rate of 3.75 to the USD. The Arab oil embargo of 1973Saudi Arabia's response to the United State's involvement in the Arab-Israeli warprecipitated events that led to the currency peg.

The effects of the short-lived embargo devalued the U.S. Dollar and led to economic turmoil. As a result, the Nixon administration drafted a deal with the Saudi government with the hope of restoring the USD to the super currency it once was. From this arrangement, the Saudi government enjoyed the use of U.S. military resources, an abundance of U.S. Treasury savings, and a booming economyan economy saturated with the USD.

At that time, the riyal was pegged to the Special Drawing Rights (SDR) currency, a bucket of several national currencies. Without being pegged to the currency fueling its oil-based economy, inflation rose. Due to high inflation and the 1979 Energy Crisis, the riyal began to suffer devaluation. To save it from total ruin, the Saudi government pegged the riyal to the US Dollar.

The currency peg restored stability and lowered inflation. The Saudi Arabian Monetary Authority (SAMA) credits the peg for supporting economic growth in its country and for stabilizing the cost of foreign trade.

Advantages of Pegged Exchange Rates

Pegged currencies can expand trade and boost real incomes, particularly when currency fluctuations are relatively low and show no long-term changes. Without exchange rate risk and tariffs, individuals, businesses, and nations are free to benefit fully from specialization and exchange. According to the theory of comparative advantage, everyone will be able to spend more time doing what they do best.

With pegged exchange rates, farmers will be able to simply produce food as best they can, rather than spending time and money hedging foreign exchange risk with derivatives. Similarly, technology firms will be able to focus on building better computers. Perhaps most importantly, retailers in both countries will be able to source from the most efficient producers. Pegged exchange rates make more long-term investments possible in the other country. With a currency peg, fluctuating exchange rates are not constantly disrupting supply chains and changing the value of investments.

Pros and cons of a currency peg

Pros of a currency peg

One of the biggest advantages of a currency peg is that it creates a win-win situation between countries that are within the currency peg. One country will pay less for goods and production, while the other country will make more profit. This is because the conversion rate between the two currencies is more favourable for both parties.

A currency peg also keeps the value of the currency low, supporting economic growth by inviting countries with more mature economies to invest. Lastly, because pegged currencies lower volatility, it reduces the risk of a currency crisis.

Cons of a currency peg

Maintaining a currency peg requires a central bank to monitor the supply and demand of each currency to ensure that there are no surprising spikes in either.

When the actual value of a currency no longer reflects the pegged price that it is trading at, problems arise for central banks, who have to work hard against excessive buying or selling of their currency. They’d do so by holding large volumes of foreign currency. And, the more reserves the bank has to maintain, the higher the inflation rate of the country.

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