Today’s economic reality includes a world of floating fiat currencies, where the value of a country’s currency is determined by supply and demand in the global foreign exchange or foreign exchange market. This was not always the case, however, as relatively fixed exchange rate systems, such as that of Bretton Woods, dominated most of the 20th century after the end of World War II.
Because fiat currencies generally lack support other than the trust and credit of the issuing government, some national central banks or monetary authorities feel the need for a mechanism independent of the forces of supply and demand to control the value of their currency.
Maintaining a fixed exchange rate or currency peg can be a solution that allows a government to gain a certain level of control over the relative value of its national currency in the foreign exchange market. A currency peg will typically involve periodic interventions by a central bank to buy or sell its domestic currency in the foreign exchange market.
Read on to learn more about currency pegs and how they could affect your Forex trading.
What is a currency peg?
Also known as a fixed exchange rate, a currency peg is the public policy of a national government, monetary authority, or central bank to fix the value of its currency at a other asset. The asset to which a national currency is pegged may be a hard currency, such as gold or silver, or another fiat currency, such as the US dollar.
In practice, implementing a currency peg generally requires that the exchange rate of the anchor currency – that is, the currency that is pegged to another currency called the anchor currency – is actively managed by a central bank or monetary authority. This authority generally uses its reserves to buy or sell the base currency against the base currency in the foreign exchange market.
Small or developing countries often establish a fixed currency with the currency of a country with a stronger, more advanced economy. This practice helps domestic companies participate more in international markets while taking considerably less foreign exchange risk than normal.
How does the currency peg work?
In practice, a monetary authority wishing to peg its currency can select a specific exchange rate in relation to another currency to which to peg its currency. A variation of this type of peg would be to specify a range of exchange rates permitted for the country’s currency in relation to another currency or basket of currencies.
The monetary authority will announce the fixed exchange rate policy to the public. It will then defend the specified fixed rate or rate band by transacting in the open foreign exchange market.
Some countries, notably China in recent years, have managed to maintain a fixed exchange rate by using strict capital controls and prohibiting the law from trading their currency at anything other than the fixed rate.
Although this type of monetary policy can be difficult to implement in practice and may even result in black market transactions, countries like China, which maintain strict government controls on currency conversion transactions, have used this type of monetary policy. method with great success.
Example of currency peg
The Chinese renminbi, whose basic unit is the yuan, has been pegged to the US dollar for most of its history. By periodically pegging its currency to the U.S. dollar, the Chinese government generally aimed to keep the value of its currency low.
As an example of the management of this currency by the People’s Bank of China (PBOC), the renminbi was pegged from 1997 to 2005 at an exchange rate of 8.3 to the US dollar. In July 2005, the People’s Bank of China gave in to heavy pressure from the US government and announced that it would lift the peg and gradually introduce a more flexible exchange rate system so that the renminbi could strengthen somewhat.
Despite this change in public policy towards a more flexible exchange rate, the renminbi has only fluctuated within a fairly narrow range between 6.04 and 7.18 per dollar from 2012 to today, as shown in the chart below. below.
Keeping the renminbi at an artificially maintained depreciated reference value has had the effect of making Chinese exports less costly for foreigners. As a result, Chinese products have become more competitive with products made in other countries, which has helped the Chinese sell more of their goods and services in international markets.
To illustrate how successful this currency-fixing policy has been in promoting products made in China, it is estimated that 70 to 80 percent of the products sold by major American retailer Walmart were made in China. U.S. officials ultimately pushed for years to raise the value of the renminbi to reduce the large trade deficit the United States regularly maintained with China.
In response and to help contain inflation in China, Chinese leaders have allowed the value of the renminbi to rise in recent years under a floating exchange rate policy based on market forces and managed by relative to a basket of currencies.
Chinese exports, however, became less competitive in global markets once the renminbi was allowed to float more freely against the dollar and other global currencies.
Advantages of a currency anchor
Currency pegging carries its own set of risks and rewards. Here are the benefits traders need to know about.
Reduced volatility and risk
The main effect of a currency peg policy for a country is to reduce the volatility of the pegged currency relative to one or more of the country’s major trading partners. This practice helps reduce the exchange rate risk incurred by domestic companies involved in international trade.
Due to the reduction of volatility and risks in the foreign exchange market, a currency peg can help reduce uncertainty, promote foreign trade and boost the economy of a country that implements it.
As a historical example, the Chinese economy has benefited greatly from its monetary parity policy. The Chinese renminbi’s peg to the US dollar has also resulted in the renminbi’s value being significantly below its purchasing power parity level, by around 35%, making life in China seem relatively cheap compared to other countries.
Disadvantages of a currency peg
To be effective and produce the desired results, a monetary anchor must rest on a fairly solid concrete basis, as well as strong public support. A failure in either of these two areas could have adverse economic consequences for all nations involved.
Setbacks to monetary policy
A fixed currency also reduces the country’s ability to set appropriate monetary policy, especially when its interest rates must follow those of the fixed-currency country. This factor could negatively impact inflation levels if one country needs economic stimulus but the other has a strong, inflationary economy. Since central banks must maintain large reserves to defend the peg, this can also boost inflation.
If the peg is set too low or too high, potential currency imbalances could defeat the purpose of the peg and the cost of defending the fixed exchange rate could outweigh the benefits to international trade.
In practice, setting a currency too low tends to lower domestic living standards, harm foreign businesses, and increase international trade tensions. Conversely, setting an exchange rate too high tends to encourage domestic overconsumption of imported goods and can trigger significant inflation when the exchange rate fails.
Why countries peg their currencies to the US dollar
Many countries have traditionally pegged their currencies to the U.S. dollar when it was on the gold standard under the post-World War II Bretton Woods system of fixed exchange rates. Although the dollar is no longer convertible to gold, it remained the world’s primary reserve currency even after the collapse of the Bretton Woods system in the 1970s.
A significant number of countries continue to peg their currencies to the US dollar or maintain an artificially reduced trading range against the US dollar, sometimes for different reasons. For example, many Middle Eastern countries like Saudi Arabia, Bahrain, Jordan, Lebanon, Qatar, United Arab Emirates and Oman peg their currency to the dollar because they do a lot of business with oil which is traded in dollars.
In Asia, Hong Kong and Macau peg their currencies to the US dollar. China also maintained a dollar peg, but now uses a floating exchange rate policy managed against a basket of currencies.
A few African countries like Djibouti and Eritrea also peg their currencies to the dollar, as do some countries close to the United States like Belize, Panama and Cuba. Several Caribbean countries, including Aruba, the Bahamas, Barbados and Bermuda, have also pegged their currencies to the dollar since their economies rely heavily on American tourism.
Importance for Forex Traders
Understanding currency pegs is important for trading in the foreign exchange market. Currency pegging was used in the past to manage exchange rates and control currency values, but it has advantages and disadvantages. China’s pegging of the renminbi to the US dollar has benefited international trade. However, to be effective, monetary anchors require solid foundations, public support and appropriate monetary policies. Some countries have opted for a policy of floating exchange rates. The interaction of currencies and exchange rate policies remains important for speculators.
Frequently asked questions
If a country pegs its currency at the U.S. dollar or U.S. dollar, its central bank or monetary authority will regularly intervene in the foreign exchange market to maintain a relatively stable, or even fixed, exchange rate for its currency relative to the dollar.
Pegging a currency reduces foreign exchange risk for companies involved in international trade, and doing so at a high level of devaluation can make a country’s goods artificially cheap, which in turn can increase its competitiveness in international markets. However, since currency pegs tend to create trade imbalances, this can lead to tensions with governments of other countries.
Currencies are pegged to keep their value stable against the currencies of one or more trading partners. This practice can be implemented to increase commercial competitiveness in foreign markets, as well as to reduce foreign exchange risk arising from foreign tourism or trade in key commodities such as oil.