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FX101: Exchange Rate Pegs

In Business and Currency by Continental StaffLeave a Comment

Currency or exchange rate pegs… ever heard of those? Maybe, maybe not; but they are an incredibly useful tool used by newer and smaller countries (mostly) to stabilize their currency and encourage international business and trade. In this edition of FX101, we give you the complete rundown.

What are Exchange Rate Pegs?

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An exchange rate peg refers to the practice of pegging, or fixing, the rate of exchange of a domestic currency to the value of another currency (or basket of currencies). Other measures of value have been used in the past as well, such as gold or silver. Fixed exchange rates are the domain of the exchange-rate regime in a country, usually the central bank; and while the practice has its pros and cons, it is usually adopted by smaller, less established nations in an effort to maintain monetary stability.

Why are Exchange Rate Pegs used?

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The answer to this question was already touched on in the previous paragraph, but exchange rate pegs are usually set in place to prevent runaway inflation and to encourage commerce by providing importers and exporters with an exact rate of exchange – thereby simplifying transactions. While not without their drawbacks, exchange pegs can do incredible things for the economy, as they allow companies and governments to engage in long-term planning, understanding that the costs of doing business will not be impacted by fluctuating exchange rates.

China is an excellent example of a country that has benefited from the use of an exchange peg. China has had its currency pegged to the US dollar for quite some time – a fact largely influenced by the fact that the United States is China’s largest trading partner. In fact, since the initial pegging back in 1994, there has only been a brief 13 month exception in which the yuan was decoupled and pegged to a basket of 13-currencies in 2015-2016. This stability in exchange, coupled with the fact that the Chinese fiscal authorities have kept the value of the yuan low (it is this point that has raised international consternation over currency manipulation), has done wonders for China’s export economy. It is doubtful whether China could have achieved anywhere near the same extent of economic growth it has enjoyed in the past few decades without its use of an exchange peg and subsequently low-valued yuan.

The benefits of exchange pegs go beyond the encouragement of trade and commerce, however. By pegging the domestic currency to a more internationally accredited currency, a nation and its central bank can acquire more credibility themselves. There is a bit of a trickle-down effect in this regard, as the discipline and renown of the institutions behind the selected currency peg rub off on the domestic currency and its own institutions.

How do Exchange Pegs work?

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While the mechanics behind exchange pegs might seem complicated at first glance, they are actually rather simple. Say a country decides to peg its currency to that of another, we’ll use Canada and the United States as examples here, with Canada pegging its dollar to USD. If the value of the Canadian dollar drops relative to the US dollar, the Bank of Canada would then be obligated to sell off some of its foreign reserves in order to buy back Canadian dollars and remove them from the market. In doing so, the value of the Canadian dollar would be driven back up until parity (or the rate at which the peg was established) with the US dollar was again reached. If the value of the Canadian dollar were to rise relative to the US dollar, the same process would work in reverse, with the Bank of Canada selling off Canadian dollars until the market value of CAD returned to the official pegged rate of exchange.

When a currency basket is used as a peg, the situation does grow a little more complicated, but it still works essentially the same way. Currency baskets are comprised of a number of different currencies, usually with different weightings (some currencies within the basket are assigned a greater weight, or importance, and impact the basket more, than others). The most common reason for a currency basket is to minimize the risk of currency fluctuations. Other benefits include a greater degree of independence when it comes to macroeconomic monetary policy, compared to when a fixed single currency peg is in use.

Downsides to Exchange Pegs

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As has been detailed above, using currency pegs can be an effective way to stabilize a country’s economy and create a steady trading environment between two or more nations. But the use of currency pegs is not without its drawbacks and dangers either. First and foremost among these is the loss of fiscal independence. A country that has pegged its currency to another is thereafter very limited in terms of its ability to use domestic monetary policy to stabilize the national economy. Pegging one’s currency to another leaves one open to the same problems affecting the other currency, with no control over a solution. In a sense, using a currency peg puts you largely at the whim of the country whose currency you have pegged your own to.

Additionally, exchange pegs can lead to currency speculation, and problems can occur when and if currencies become de-pegged. These problems largely stem from imbalances that grow between the country that has pegged its currency and the country it has pegged its currency to. When currency becomes de-pegged, it can cause a great deal of fluctuations in that currency, potentially causing the very issues the peg was supposed to limit or prevent. Other causes could be the initial rate at which the peg is set. If the central bank sets a peg that does not seem credible, speculation could occur that could place a great deal of pressure on the bank. The use of a drifting peg, in which the parameters for the fluctuation of the peg’s value are explicitly stated, can sometimes help to remove the risk of speculation, allowing for a controlled re- or de-evaluation.

How do Currency Pegs affect Exchange Rates?

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As previously discussed, currency pegs set a stable rate between two currencies, allowing for greater ease of exchange and encouraging commerce and trade. Tourism is just one other area that has the potential to benefit from a currency peg. The stability created through the use of pegs means there is a far reduced chance of volatile currency fluctuations, meaning the rate you got when you went to pick up some cash in preparation for your trip will almost certainly be the same (or very similar) to the one you get a few weeks later when you are in that country and making payments. Even if that country uses a drifting peg, the fluctuations which that peg will allow will in all likelihood take place far too gradually for you to notice, and that is the point. Currency pegs are all about restoring stability and confidence in the local economy. You’re sacrificing independence, but benefiting from the reliability of the central bank whose currency has been selected for the peg; and let’s be honest, for the average person, stability is a very good thing.

From the history of money to interest rates, we delve deep into the world of foreign exchange with FX101.

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