A brief look at pegged currencies across the world
A highly attractive nation for investment will experience growth in it’s currency value, whereas a nation in trouble will experience a weakening currency. To decrease the volatility, many nations have linked their currencies at a constant rate to the US dollar or the euro.
A pegged exchange rate is a fixed exchange rate between two countries. A government initiates a currency peg by pegging it’s currency value to that of another country. It provides the importers and exporters with a stable trading environment by administering them with the expected exchange rates and limiting uncertainties like inflation, or interest rates that could inhibit dealing between two countries.
Some pegs have been in place for long (Hong kong to the US dollar since 1983), as it provided stability and fostered trade. Large amount of foreign reserves need to be kept to keep a peg in place.
What are the advantages of a pegged currency?
- Inhibition of currency fluctuations is advantageous to the firms engaged in trade. If a firm’s raw materials are imported from a country, a devaluation of the currency simply increases the cost of production in turn decreasing the profits. Similarly, appreciation in a currency can hamper the exports as the products cost more and escalates the competition from other countries.
- Buyers and sellers can easily settle on the prices of various commodities on the global level as no fluctuations and risks are associated with the currency rates.
- It is a base for the export oriented businesses as the competition faced due to changing rates is removed. This leads to more investment in a country.
- The values become predictable which is helpful to the online traders. Eg – When the US dollar is predicted to increase, a trader can invest in any of the pegged currencies, as an increase in the value will artificially result in increase of the value of it’s pegged currency.
- It enables the government to keep the inflation low.
But, this isn’t always the case. There are some disadvantages to the currency pegs –
- Large foreign reserves are required to keep the currency pegged and the opportunity costs related to these can prove to be expensive for a country.
- The right time to join is unpredictable. A very high rate will make exports uncompetitive and very low rates will cause inflation.
- Fixed rates can cause current account imbalances. Current account deficit can be caused by an overvalued exchange rate.
- It becomes more challenging to respond to the temporary shocks.
- The central bank has less control over interest rates.
- Less opportunity is available to make profits on the forex market.
- The monetary independence of a country is lost.
Many small nations peg their currency to the US dollar if the primary source of their revenue is the US dollar. It helps them stabilise the economy, which wouldn’t be able to withstand the volatility.
The Current Scenario
Some currencies connected to the dollar became vulnerable in 2016 from traders speculating that it’s changing into too expensive to continue defending them. The lag in China’s economy placed pressure on Hong Kong’s peg, whereas Saudi Arabia cracked down on bets against the riyal once the collapse in oil costs. Currency markets are roiled since August, when China cut the worth of the yuan for the first time in 2 decades; the country burned through over $500 billion of its reserves in 2015.
Egypt and Nigeria conjointly effectively devalued last year, as did Argentina.
Schweiz appalled traders by scrapping the franc’s three-year-old cap against the euro in early 2015, that forced the financial organisation in Denmark to defend the krone’s tie-up to the monetary unit. Although the currencies of most massive countries and also the 19-nation euro float freely, the trend has been heading the opposite way: 35% of nations monitored by the IMF (International Monetary Fund) gave the market freedom in 2015, down from 40% in 2008.
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