RogerL
08-04-2004, 03:10 AM
There have been some questions on how a currency peg works. I thought I'd try to answer that with a simplified explanation of fixed exchanged rates and currency pegs.
Most countries use a floating exchange rate. In other words, the value of a currency is purely decided by supply and demand. Central banks do occasionally intervene to bolster a floating currency, but this is typically a very unusual occurrence.
* How does a peg work? *
A peg is essentially a fixed exchange rate that is fixed against a currency or basket of currencies. The government promises to maintain that specific exchange rate within a limited band above and below the specified exchange rate.
There are generally two agents that can be used to maintain that rate. The first type is the central bank. The definition of a central bank is "the lender of last resort," in other words the entity which facilitates liquidity by lending money to banks when banks run low on currency and demand deposits (sum of deposits making up a bank's assets). Not only is a central bank responsible for printing money, but it also conducts a monetary policy to ensure there is an adequate amount of money in the economy without triggering significant inflation or deflation.
The second type is the currency board. A currency board is not a central bank. It does not lend money to banks. The sole responsibility of a currency board is to maintain the exchange rate between the local currency and the pegged currency. It must maintain a reserve of 100% of the value of the local currency in the pegged currency. So say a country has 1 trillion dinars circulating and wants to maintain a 1:1 exchange rate with the US dollar, the currency board must hold $1 trillion in US currency. In practice, many currency boards do not hold exclusively currency. An alternative is to hold highly liquid debt securities from the pegged country or countries.
To maintain the exchange rate within a certain trading band, the currency board or central bank must be ready to trade quickly. In the case of dinars backed by dollars, if the dinars begin to depreciate, it must buy dinars with dollars until the exchange rate comes back into range. In the case where the dinar begins to appreciate, it must buy dollars in exchange for dinars.
A central bank is not obligated to hold 100% of the value of the local currency in the pegged currency, but is obligated to exchange those currencies on demand. Typically, a large amount of pegged currency is held, but other assets can be used to obtain the pegged currency such as oil.
* Advantage and Drawbacks *
Why does a country use a peg instead of a float? Typically it is done in an environment that is fairly volatile, politically and economically. In order to attract foreign investors, it's beneficial for a government to give those investors confidence that their investments will be stable and not subject to wild swings in the exchange rate. So the advantage is that the country is able to offer not just a more stable investment environment, but also able to strengthen its currency beyond what it would be if the currency were left to float. It does this, though, at the cost of having monetary policy taken out of the government's hands.
If the pegged currency appreciates, the wealth of the local population grows since foreign goods become cheaper to buy if the government can easily maintain the exchange rate.
The disadvantage comes in when the pegged currency strengthens considerably. Two things can happen. As the pegged currency gets stronger, so does the local currency. This leads to a current account deficit (trade deficit) since local goods become more expensive to buy. Unemployment rises as exports drop. What typically happens in this case is that the local currency is re-pegged at a lower exchange rate (devaluation). Each time that happens, though, confidence in the economy goes down.
The second thing that can happen is far worse. The pegged currency can appreciate beyond the capability of the country to support the exchange rate. Panic sets in among currency holders that the government will not be able to maintain the exchange rate. Essentially a "run" happens and hard currency reserves are bled dry and leaving insufficient local currency available in the economy. Economic chaos is usually the result as the local currency goes into freefall. Such a thing happened a few years back with Argentina as their currency board was unable to maintain the exchange rate.
Depreciation of the pegged currency can help or hurt. A minor depreciation helps by making local goods cheaper, thus boosting exports and creating additional jobs. It hurts if depreciation is severe since that essentially destroys the wealth of its citizens as foreign goods become too expensive to buy. The latter scenario is not typical since pegged currencies are usually the strongest of the major industrialized nations: the United States, the UK, or the Euro, though occasionally pegs are done on the major trading partners of that country instead.
Pegs on a major trading partner are often helpful. When the currency strengthens, the now wealthier pegged country often buys more goods, pouring more hard currency into the country, making everyone wealthier. Since foreign reserves grow, the country can release more local currency without fear of inflation.
There are tons of other scenarios that can happen, but this post has already gotten to be fairly long and complicated, so I'll just end it here. Hopefully this helps somewhat.
Most countries use a floating exchange rate. In other words, the value of a currency is purely decided by supply and demand. Central banks do occasionally intervene to bolster a floating currency, but this is typically a very unusual occurrence.
* How does a peg work? *
A peg is essentially a fixed exchange rate that is fixed against a currency or basket of currencies. The government promises to maintain that specific exchange rate within a limited band above and below the specified exchange rate.
There are generally two agents that can be used to maintain that rate. The first type is the central bank. The definition of a central bank is "the lender of last resort," in other words the entity which facilitates liquidity by lending money to banks when banks run low on currency and demand deposits (sum of deposits making up a bank's assets). Not only is a central bank responsible for printing money, but it also conducts a monetary policy to ensure there is an adequate amount of money in the economy without triggering significant inflation or deflation.
The second type is the currency board. A currency board is not a central bank. It does not lend money to banks. The sole responsibility of a currency board is to maintain the exchange rate between the local currency and the pegged currency. It must maintain a reserve of 100% of the value of the local currency in the pegged currency. So say a country has 1 trillion dinars circulating and wants to maintain a 1:1 exchange rate with the US dollar, the currency board must hold $1 trillion in US currency. In practice, many currency boards do not hold exclusively currency. An alternative is to hold highly liquid debt securities from the pegged country or countries.
To maintain the exchange rate within a certain trading band, the currency board or central bank must be ready to trade quickly. In the case of dinars backed by dollars, if the dinars begin to depreciate, it must buy dinars with dollars until the exchange rate comes back into range. In the case where the dinar begins to appreciate, it must buy dollars in exchange for dinars.
A central bank is not obligated to hold 100% of the value of the local currency in the pegged currency, but is obligated to exchange those currencies on demand. Typically, a large amount of pegged currency is held, but other assets can be used to obtain the pegged currency such as oil.
* Advantage and Drawbacks *
Why does a country use a peg instead of a float? Typically it is done in an environment that is fairly volatile, politically and economically. In order to attract foreign investors, it's beneficial for a government to give those investors confidence that their investments will be stable and not subject to wild swings in the exchange rate. So the advantage is that the country is able to offer not just a more stable investment environment, but also able to strengthen its currency beyond what it would be if the currency were left to float. It does this, though, at the cost of having monetary policy taken out of the government's hands.
If the pegged currency appreciates, the wealth of the local population grows since foreign goods become cheaper to buy if the government can easily maintain the exchange rate.
The disadvantage comes in when the pegged currency strengthens considerably. Two things can happen. As the pegged currency gets stronger, so does the local currency. This leads to a current account deficit (trade deficit) since local goods become more expensive to buy. Unemployment rises as exports drop. What typically happens in this case is that the local currency is re-pegged at a lower exchange rate (devaluation). Each time that happens, though, confidence in the economy goes down.
The second thing that can happen is far worse. The pegged currency can appreciate beyond the capability of the country to support the exchange rate. Panic sets in among currency holders that the government will not be able to maintain the exchange rate. Essentially a "run" happens and hard currency reserves are bled dry and leaving insufficient local currency available in the economy. Economic chaos is usually the result as the local currency goes into freefall. Such a thing happened a few years back with Argentina as their currency board was unable to maintain the exchange rate.
Depreciation of the pegged currency can help or hurt. A minor depreciation helps by making local goods cheaper, thus boosting exports and creating additional jobs. It hurts if depreciation is severe since that essentially destroys the wealth of its citizens as foreign goods become too expensive to buy. The latter scenario is not typical since pegged currencies are usually the strongest of the major industrialized nations: the United States, the UK, or the Euro, though occasionally pegs are done on the major trading partners of that country instead.
Pegs on a major trading partner are often helpful. When the currency strengthens, the now wealthier pegged country often buys more goods, pouring more hard currency into the country, making everyone wealthier. Since foreign reserves grow, the country can release more local currency without fear of inflation.
There are tons of other scenarios that can happen, but this post has already gotten to be fairly long and complicated, so I'll just end it here. Hopefully this helps somewhat.