Is Pegged Foreign Exchange Rate Better?

Is Pegged Foreign Exchange Rate Better?

16 Jan 2020 05:08 PM
 

The foreign currency exchange rates can determine the relative strength of one country's currency to another since the disparity is manifested in the value gap observed upon currency exchange. The factors that hold influencing power over the economic condition of a country include the inflation rate, government stability, geopolitical conditions, prevailing interest rates and many more. In turn, these factors drive the fluctuations in the foreign exchange rates due to the changes brought in any currency's value, subsequently influencing the forex transactions. Any transaction in the foreign exchange market bears the impact of the market movements and also affects the international trade that happens between economies. However, in the case of the pegged foreign exchange rate, the market conditions do not contribute to the forex risk of exchange rate uncertainty since pegging a currency stabilizes the exchange rate between countries.

The currency peg basically empowers the country's business planning by offering long term predictability of exchange rates. When the value of a country's currency is tied to a usually stronger currency like the Euro, UK pound sterling or US dollar, it is referred to as a pegged exchange rate or fixed exchange rate. The main objective of pegging the rate at a predetermined ratio of another currency by the monetary authority is to stabilize the exchange rate by pegging it to a more stable and internationally prevalent currency. The government sets the fixed or pegged rate against a major world currency wherein the central bank buys and sells its own currency in the foreign exchange market to maintain the exchange rate. The participating countries agree upon an initial target rate when pegged rate agreements are set up, which necessitates several reviews over their lifetimes to adapt the target rate to the changing economic climate. Additionally, the agreement usually also entails the acceptable range of exchange rate fluctuations causing deviations from the target exchange rate.

For example, take a scenario in which $6 is equal to the value of a single unit of a local currency wherein the supply of these dollars in the market will be ensured by the central bank.  In order to maintain the rate, a high level of foreign reserves must be maintained by the central bank, which can be used to release or absorb extra funds into or out of the market. The primary objective that the foreign reserves will ascertain is to corroborate an appropriate money supply and manage fluctuations in the market to ensure the exchange rate ultimately. 

Merits of a pegged exchange rate

Countries prefer the pegged exchange rate regime due to the predictability of the exchange rate it extends and the profitability factor offered for trade and exports purposes. The fluctuation susceptibility of smaller economies is reduced due to pegging, which also strengthens the morale of larger economies in setting up trade deals owing to the rates that will not fluctuate beyond reasonable levels.

  1. Trade relationships with countries One of the major advantages that pegged exchange rates bring to smaller economies is that by controlling its domestic currencies, the exchange rates can be kept low, which aid the competitiveness of goods in the international market. Another merit is the profitability that trade relations between countries with low production costs harbour with countries with comparatively stronger currencies. When manufacturers from China and Vietnam translate their earnings to their home currencies, a greater amount of profit is earned, ultimately facilitating domestic products' competitiveness abroad and profitability at home. 
  2. Currency protection  Beyond the trade outlook, pegged exchange rates also corroborate a rise in the standard of living along with overall economic growth. Fortifying the domestic currency's value against the adverse foreign exchange swings adds a layer of protection wherein the possibility of encountering a currency crisis can be reduced by the government.  One example of this merit extended by the pegged exchange rate is when China, in 2008, decided to go back to a fixed exchange rate regime during the global financial crisis. The decision enabled the Chinese economy to emerge relatively unscathed two years later.

Demerits of a pegged exchange rate

The need to maintain the fixed exchange rate and the measures that the government needs to take to ensure that, encompass the disadvantages associated with the pegged exchange rate. As the central bank is constantly buying and selling domestic currency,  large foreign reserves need to be maintained wherein the massive amount of capital created can create economic side effects like inflation. Due to the directly proportional relation between currency reserve and monetary supply, the prices continue to rise, causing troubles for countries that are inclined to keeping things stable. Before revoking the fixed-rate scheme in 2010, China's foreign reserves grew substantially higher each passing year to maintain the US dollar peg rate, surpassing Japan's foreign exchange reserves with Beijing owning $2.8 trillion in reserves by January 2011.

While pegged exchange rate might empower countries to defend against the adverse global situation, they often fall short in navigating domestic situations. The Thai baht suffered tremendously following adverse market events during 1996-1997, the time it was pegged to the US dollar. Due to the government's unwillingness and inability to defend the baht due to limited reserves, the currency depreciated, and the value of the baht plunged. Thus, ultimately in July 1997, the Thai government was forced into the floating exchange regime with the baht value dropping as much as 40%.

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 felt on the corporate's bottom line. Thus through forex training for corporate, one can stay tuned to the nitty-gritty of the foreign exchange market and ensure appropriate actions are taken when required. Myforexeye provides forex training to corporates who want their finance team to stay abreast of all the latest developments in the foreign exchange markets. Besides empowering corporates with the right forex knowledge, our services dwell deeply into simplifying forex so that one can enhance their savings from their forex transactions. Quick and cost-efficient quotes for buyer's credit, supplier's credit, export factoring and LC bill discounting are some of the effective solutions that we extend, beyond which forex risk management, transaction process outsourcing, strengthened forex strategies, live forex updates, expert consultation are the other accessible benefits. 

Conclusion

Myforexeye is your destination to get all your forex needs, whether it be individual or organizational and irrespective of their scale,  resolved. Our Specialized team is armed with advanced technology and the expertise of experienced professionals to extend convenient solutions that simplify forex for you while dispensing important information and quality research. Our user-friendly web portal and mobile app reinforced by our transparent streamlined process and service empower users to make savings and insight into real-time rates and best quotations from banks to equip you with the best possible options. One can also mitigate their forex risks through our expert consultation and risk advisory services available on a transitional basis and available whenever the need for it arises.

Speak to one of our specialists to acquire a detailed understanding of Myforexeye forex services.

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