Pegged Exchange Rate Essay

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A pegged exchange  rate  exists when a government fixes the  value of its country’s currency  to  that  of another  country or group of countries  (the reference currency/currencies). As a result, when the value of the reference  currency/currencies rises, so does the value of the pegged currency, and when the value of the reference currency/currencies falls, so does that of the  pegged currency.  Pegged exchange rates  can be seen as an attempt  to create a fixed exchange rate zone in the midst of a floating exchange rate system and are most often implemented  by developing country governments as a way of creating currency stability and reducing inflationary pressures.

A recent  example of a successful currency  peg is that of the Chinese yuan. From 1994 to 2005, the Chinese government  pegged the value of the yuan to the U.S. dollar at a rate of $1 = 8.28 yuan. In essence, this created a fixed exchange rate zone between the U.S. dollar and Chinese yuan, reducing currency exposure for companies doing business between the two countries. However, many outside China, including some members  of the U.S. government,  suggested the peg was increasingly keeping the  yuan at an artificially low exchange rate and was fueling a boom of Chinese exports that was hurting  not only producers  in China’s export markets  (like the United States) but also those in countries  attempting  to compete  with Chinese exports (like other Asian producer nations).

To  keep  the  yuan  from  rising  above  its  pegged value, the Chinese government was forced to buy U.S. dollars (increasing the demand  for them, and therefore  supporting   their  value) through  issuing  more yuan (increasing  the  supply of them,  and  therefore suppressing a rise in their value, but risking inflationary pressure as the domestic money supply expands). Amid much international discussion, the Chinese government  announced,  in July 2005, that they were releasing the peg to the U.S. dollar in favor of a more flexible link to multiple currencies, including the euro, the yen, and the U.S. dollar. They also announced  an immediate  increase in the value of the yuan against the U.S. dollar of 2.1 percent, as well as greater day-to-day flexibility of the yuan rate versus the dollar and other currencies. As of August 2008, three years after this announcement, the yuan/dollar exchange rate had moved from 8.28 yuan/dollar to 6.86 yuan/dollar.

The unpegging of an exchange rate is not always so orderly. In 1978 the Thai government  pegged that country’s currency to the U.S. dollar at a rate of $1 =25 baht. Through several decades of rapid economic growth, the peg provided reassurance to foreign investors  in Thailand, who felt confident  in pursuing the  higher  returns  available there,  because  the peg allowed them  to convert  both their profits and, if desired, their capital, back into U.S. dollars at the “fixed” exchange rate. Thus, if an investment  in the United States yielded a 5 percent  return,  and one in Thailand a 10 percent  return,  there seemed to be no risk in accepting  the 10 percent  return,  because, as long as the peg held, there  was no potential  for the return to be eroded by a dropping Thai baht.

This dynamic of high returns and no perceived currency exposure drew increasing investment into Thailand. Despite concerns  that  growth  was overheated and, in some cases, misdirected, the Thai government maintained  its commitment to the peg. On June 30, 1997, the  Thai prime  minister  announced  that  the Thai baht would not be devalued, but two days later, after intense speculative attack, the peg was released, and  the  baht  became  a floating currency.  The Thai economy  was in distress,  and  six months  later, the Thai baht traded at 56 to the U.S. dollar.

What makes one currency peg succeed and another fail? For one thing, the Chinese government had huge foreign  currency   reserves  and   was  accumulating more every day because of its large trade surpluses, while the Thai government had more limited reserves to address the problem. Second, the Chinese government maintained  controls on the convertibility of its currency,  therefore  controlling  the  amounts  investors or currency speculators  could buy or sell, while Thailand  did  not  have  these  controls.  Finally, the widely held perception was that the Chinese yuan was undervalued  and  should  rise, while the  perception with regard to the Thai baht was the opposite, spurring speculative action  and withdrawals  of invested funds. However, even successful currency  pegs, like China’s, can lead to negative consequences,  such as domestic inflation and international pressure, as they are seen as thwarting market forces in a world of floating exchange rates.

 

Bibliography: 

  1. Paul   Bergin  and   Robert   C.  Feenstra,  Pass-Through of  Exchange Rates  and  Competition Between Floaters and Fixers (National Bureau of Economic Research,  2007);
  2. Lorenzo Cappiello  and  Gianluigi  Ferrucci, The Sustainability  of China’s Exchange Rate Policy and  Capital  Account  Liberalisation  (European   Central Bank, 2008);
  3. Eernisse and T. Meehan. “The Great Currency Debate,” The China Business Review (v.35/3, 2008);
  4. Morris Goldstein and Nicholas R. Lardy, Debating China’s Exchange Rate Policy (Peterson Institute  for International Economics, 2008);
  5. Robert Lafrance, China’s Exchange Rate Policy: A Survey of the Literature (Bank of Canada, 2008);
  6. Maurice Obstfeld, The Renminbi’s Dollar Peg at the Crossroads (Institute for Monetary and Economic Studies, Bank of Japan, 2007);
  7. Inci Ötker-Robe and David Vávra, Moving to Greater Exchange Rate Flexibility: Operational Aspects Based on  Lessons From  Detailed  Country  Experiences (International Monetary Fund, 2007).

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