How Does a Currency Peg Work?If you’ve been following the news recently, you’ll have seen last week’s decision by the Swiss National Bank to remove the cap on the Franc, which was pegged to the Euro. The reasons behind their decision are difficult to understand, but what’s also quite tricky is the idea of the fixed exchange rate itself, so let’s try explain what that is first!
What Is A Pegged Exchange Rate?Investopedia (a great site to learn about all things finance related) define a Pegged Currency as; “A country or government’s exchange-rate policy of pegging the central bank’s rate of exchange to another country’s currency. Currency has sometimes also been pegged to the price of gold. Currency pegs allow importers and exporters to know exactly what kind of exchange rate they can expect for their transactions, simplifying trade. This in turn helps to curb inflation and temper interest rates, thus allowing for increased trade.“. It might surprise you just how many nations have their currency fixed to another. Danish Kroner is pegged to the Euro, while the list of nations pegged to the US Dollar is quite long, including Hong Kong, the UAE, Saudi Arabia, Kuwait and Venezuela. Fixed exchange rates became a “thing” in the UK around 1821 with the adoption of the Gold Standard, and other major world currencies followed soon after. What this meant was that “the external value of all currencies was denominated in terms of gold with central banks ready to buy and sell unlimited quantities of gold at the fixed price. Each central bank maintained gold reserves as their official reserve asset.” (thanks Wikipedia!) After World War II the Bretton Woods system was introduced, and the US Dollar replaced Gold as the official reserve asset (although the Dollar itself was still tied to Gold). The IMF took charge, and the 44 member states all agreed to maintain exchange rates within 1% of parity through their foreign exchange markets by buying or selling foreign money. In March 1973, the Floating Exchange Rate came to be, and it’s this model we recognise around the world today. So why would a country make the decision to peg their currency to another? There are many advantages, including;
- Central banks (of smaller, newer nations) can acquire credibility by fixing their country’s currency to that of a more disciplined (established) nation
- A fixed exchange rate reduces volatility and fluctuations in relative prices
- International trade and investment ﬂows between countries are facilitated
- Flexible exchange rates can serve to adjust a trade deficit – under fixed (pegged) exchange rates, this automatic re-balancing does not occur
- The announced exchange rate may not coincide with the market equilibrium exchange rate, thus leading to excess demand or excess supply
- The central bank needs to hold stocks of both foreign and domestic currencies at all times