Pegged Exchange Rate Essay ⋆ Business Essay Examples ⋆ EssayEmpire

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:

Paul Bergin and Robert C. Feenstra, Pass-Through of Exchange Rates and Competition Between Floaters and Fixers (National Bureau of Economic Research, 2007);
Lorenzo Cappiello and Gianluigi Ferrucci, The Sustainability of China’s Exchange Rate Policy and Capital Account Liberalisation (European Central Bank, 2008);
Eernisse and T. Meehan. “The Great Currency Debate,” The China Business Review (v.35/3, 2008);
Morris Goldstein and Nicholas R. Lardy, Debating China’s Exchange Rate Policy (Peterson Institute for International Economics, 2008);
Robert Lafrance, China’s Exchange Rate Policy: A Survey of the Literature (Bank of Canada, 2008);
Maurice Obstfeld, The Renminbi’s Dollar Peg at the Crossroads (Institute for Monetary and Economic Studies, Bank of Japan, 2007);
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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