Is Pegged Foreign Exchange Rate Better?

Is Pegged Foreign Exchange Rate Better?

16 Jan 2020 05:08 PM

Pegged exchange rate is the fixed rate at which the currency is converted from one to another. The rate is fixed by the monetary authority to order to stabilize the rate of exchange at a predetermined ratio of another currency which is more stable and internationally prevalent. In a pegged exchange rate, the market conditions do not change the peg, making the trade and investments simpler between the two economies which are relatively smaller in size and borrow in foreign currency.

A look back at fixed exchange rate regime

In order to exchange commodities through cross border trades, the countries started using the gold standard in the 17th century where the value of all currencies was denominated in gold at a fixed price for unlimited quantities of gold to buy or sell by central banks. The banks maintained the gold reserves for their country.

Post the World War II, the Bretton Woods system made US Dollar as the reserve currency replacing the gold standard. Through International Monetary Fund (IMF), an order was passed amongst the sovereign states to establish a parity of their national currencies in US Dollar. They had to maintain the exchange rate within a 1% of parity, through buying or selling foreign money from their dollar reserves by intervening in their foreign exchange markets. With dollar being the only currency to meet the burgeoning demand for international currency transactions, it became the reserve currency.

But with rising speculation and shift of liquid money from US, in 1973 the independent float came into being terminating the Bretton Woods system. Post this, the countries chose what would work best for their currency. They could have it pegged to another currency or a basket of currencies or even leave it at the helm of the market to determine its currency value.

Reference or fixed rate merits and demerits

There is a reference rate which is currency is pegged is pre-determined and thus the reference rate rises or falls along with the value of any currency pegged to it. The value of other currencies and commodities also rise and fall accordingly. How a currency behaves is also managed through the fixed exchange rate system by limiting the inflation rates as mentioned before. Thus a pegged exchange rate prevents a government from using its monetary policy to achieve macroeconomic stability. Apart from that, it helps create stability for the currency and thus attracts foreign investments and also promotes exports due to non-fluctuation currency.

In order to maintain the pegged rate, the central bank of the economy uses the open market mechanism to buy or sell the domestic currency in a pegged exchange rate system. To buy or sell the currency, it is expected to maintain sufficient forex reserve which is used to ensure the fixed price of its currency is adhered to. So if the local currency appreciates, the central bank through the public sector banks will buy the foreign currency and sells the domestic currency. This addition of local currency in the market makes it lose its value and thus depreciates. Similarly, when the foreign currency appreciates, the forex reserves are used to sell the foreign currency and thus buy back local currency. This artificial creation of demand for the domestic currency increases its exchange rate value or appreciates the local currency. Thus maintaining forex reserves is of importance to ensure equilibrium in the intended pegged value of the exchange rate.

It has limited flexibility to tackle sudden events and shocks. Technologically driven markets are so infused to each other especially in times of shocks that the central bank is unable to respond to arrest such volatility which may hamper the value of the domestic currency.

Is fixed exchange rate still prevalent?

Most economies shifted from pegging their currencies due to the above mentioned risks in the exchange rate. It is the large economies which typically do not fix their exchange rate and People’s Bank of China (PBoC) which was the last large economy to do so also moved to a managed exchange rate regime which is slightly more adaptive in nature making it a flexible exchange rate. Before joining the Eurozone, countries used the European exchange rate mechanism temporarily to establish the conversion rate against the Euro from the domestic currencies.

Mainly tourism driven countries pegged their currency to the US Dollar as tourism is the main source of income for such countries. Recent currency manipulator tag removal on China from the US made the Chinese Yuan appreciate which has been embroiled in currency policy controversies.

About a dozen economies still peg their currencies which are small in size mainly from Africa, Caribbean islands, Asia, Middle East, namely, Bahrain, Belize, Cuba, Djibouti, Eritrea, Hong Kong, Jordan, Lebanon, Oman, Panama, Qatar, Saudi Arabia, United Arab Emirates are some countries which have fixed their exchange rate to the US Dollar and Euro. Some African countries peg their currencies with Euro.

Fixed versus floating exchange rate

Major currency pairs are floating in nature wherein they let the currency value change as per the currency demand and supply in the foreign exchange market. The market forces determine these rates. The economic events released move the currency based on the sentiments and expectations of the currency. The central bank’s policy decisions or employment numbers, growth expectations or inflationary pressure, etc make the currency move thereby letting the market forces determine the movement of the currency.

Understanding the foreign exchange market, helps to identify the movement of each economy’s currency and thus adopt suitable foreign exchange strategies to ensure the impact of forex volatility isn’t effected on the corporate’s bottomline. Most small and medium enterprises are unaware of global currencies and their impact of their exports or imports. Thus through forex training for corporate, one can stay tuned to the nitty gritties of the foreign exchange market and ensure appropriate actions are taken when required. Myforexeye provided forex training to corporates who want their finance team to stay abreast of all the latest developments in the foreign exchange markets.

Recommended for you...