Currency Pegs


In the rise and fall of world powers, the currency market keeps score. A nation’s money gains value when it’s a magnet for global investors; in times of trouble it weakens. The volatility can create havoc. To keep things in check, more than half of all countries have fixed the value of their money to another currency — mostly the U.S. dollar or the euro. They’ve hammered in a peg. The tie-ups can provide stability and foster trade, as Hong Kong’s link to the dollar has since 1983. Until they don’t. To hold most pegs in place, the central bank must use foreign reserves to buy or sell in currency markets in a battle with traders to keep the exchange rate stable. If pressure builds, policy makers will be forced to give up. The peg will slip or break — with sometimes disastrous consequences.

The Situation

China surprised global markets in August with its first major devaluation of the yuan since 1994, as an economic slowdown weighed on the currency. The shift mounted pressure on trading partners, with Vietnam marking down its currency and Kazakhstan moving to a free float the same month. Further weakness in the yuan in early 2016 caused the Hong Kong dollar to slip amid speculation that its peg to the U.S. dollar could be ended. A year earlier, Switzerland shocked  traders by scrapping the franc’s three-year-old cap against the euro. The move forced the central bank in Denmark to defend the krone’s tie-up to the euro by repeatedly cutting interest rates. Russia struggled to halt the ruble’s steepest slide in 17 years in late 2014 as oil prices plunged. It abandoned efforts to manage the ruble’s flexible, or crawling, peg against a basket of currencies after spending more than $88 billion of its reserves. Both Egypt and Nigeria also effectively devalued in 2015, as did Argentina. Though the currencies of most large countries and the 19-nation euro float freely, the trend has been heading the other way: 35 percent of countries monitored by the International Monetary Fund gave the market free rein in 2015, down from 40 percent in 2008.

Source: IMF, Bloomberg News
Source: IMF, Bloomberg News

The Background

There are various systems for managing exchange rates, and some are more stable than others. Panama and Zimbabwe simply use the U.S. dollar as legal tender. Fixed rates are employed in countries from Bulgaria to Saudi Arabia to Venezuela. Singapore and China have employed different types of links to currencies of trading partners via bands that can move up or down. China has mostly used the arrangement to limit appreciation over the last decade, though it’s now allowing the yuan to fluctuate more in response to market forces. Hong Kong’s peg has been seen as virtually impregnable because the total amount of local currency issued is backed by U.S. dollars in reserve, an arrangement known as a currency board. History is full of upheavals. The 1971 “Nixon shock” was sparked when President Richard Nixon abruptly ended the dollar’s convertibility to gold. It led to the end of the post-World-War-II Bretton Woods system that pegged currencies of industrialized countries to the U.S. The U.K. faced a storm in 1992, when investors including George Soros bet it wouldn’t be able to keep its pound within a pre-euro system of linked rates. It gave in on Sept. 16 and allowed the pound to float, a day known as Black Wednesday.

The Argument

Currency pegs can put a central bank at the mercy of another country’s monetary and fiscal policy, so it must copy moves on interest rates. There’s less freedom to respond to domestic goals, such as reviving growth, creating jobs or containing prices. In Hong Kong, for example, easy-money policies in the U.S. have caused a surge in inflation and home prices. Then weakness in the yuan and a sell-off of Chinese stocks put pressure on the local currency to follow suit. So why peg? More predictability for companies and investors. Tying policy makers’ hands can also lead to more disciplined government spending. For a peg to hold, the exchange rate must be set judiciously and kept in line. Since there’s no automatic rebalancing from trade flows, it’s easy for a peg to get out of whack. That can cause a currency to lose credibility and come under attack. Some countries -– like China, Egypt and Venezuela -– keep speculators at bay with capital controls that limit how much currency can be converted or rules that require banks to trade near official rates.