Not having predictability in a currency’s value can create scenarios where a country’s economy is thrown into turmoil overnight. This is problematic for smaller countries because these types of changes can throw their economies into a free fall.
Pegging a currency against another foreign currency — especially a major trading partner — is a strategy that provides some protection. This process is called using a fixed exchange rate. But what exactly is a fixed exchange rate, and what does it mean for those doing business internationally?
Understanding the Basics of Fixed Exchange Rates
A fixed exchange rate is when a currency is tied to the value of another currency, which is also called “pegging.” Many countries today peg their currencies against the US dollar or the euro. Why?
The goal of fixing domestic currency is to create stability. A country wants their currency to be stable for the sake of imports and exports, and to encourage investments.
A currency can be fixed in a couple of ways, including:
- Fixed to the value of gold; X amount of a currency is fixed to Y amount of gold.
- Fixed to a major currency; X amount of a currency is worth one US dollar or one euro.
The Origin of a Fixed Exchange Rate
In 1944 World War II had just ended, and the Allied nations had a mutual problem. Many of them had printed a large amount of money to finance the war effort and were looking for mutual stability to stabilize their countries’ economies.
Additional printing of money during the war resulted in hyperinflation because there was more money than demand. In some countries, the value of their currency dipped so low that people needed a wheelbarrow full of money just to buy a loaf of bread. After the war, countries were eager to get back to the gold standard and to prevent future challenges.
It was agreed that the US dollar would become the replacement for gold. As a result, the value of the dollar grew compared to other worldwide currencies.
An agreement was made that all countries present, and their central banks, would maintain a fixed exchange rate between their currencies and the US dollar.
Prior to this agreement, most countries, including the United States, followed the gold standard. Entering into the agreement meant that a country would redeem their currency for dollars instead of gold. But why did they peg their currencies against the US dollar?
At the time, the United States held about three-fourths of the world’s gold. No country had enough gold to back it as a replacement, so it was agreed that the US dollar would become the replacement for gold. As a result, the value of the dollar grew compared to other worldwide currencies.
The Advantages of a Fixed Exchange Rate Policy
The main advantage of a fixed exchange rate system is that it provides countries with additional safety and security. For example, if a country is constantly working to keep their currency pegged against the US dollar or the euro, the risk of flooding their economy with the printing of additional currency is less.
Some advantages of a fixed exchange rate include:
Currency fluctuations can be avoided
When a currency is not pegged to another the value of that currency may be subject to dramatic upswings and downturns. These sharp fluctuations can be problematic for trading.
For example, let’s say that a firm is exporting their product to another country. Suddenly, the value of their currency surges. The increase in the currency’s value might seem like a good thing, but it actually creates a new set of challenges. Trading partners might decide that because of the increased currency value, the products are no longer affordable, and they may halt their purchases.
Stability attracts investors
It’s difficult to invest in a country whose exchange rates have the potential to fluctuate rapidly. Investing funds only for the value of the currency to change drastically could lose a large sum of money. For this reason, a country that uses a fixed exchange rate encourages investments within the country from foreign investors.
It provides safety for inflation challenges
A country without a fixed exchange rate is vulnerable to inflation. Without the pressure of their currency pegged to the chosen currency, they may be tempted to print more currency during difficult times.
The Disadvantages of a Fixed Exchange Rate
A fixed exchange rate provides a country with greater stability, but along with this stability comes drawbacks. The country and its central bank must ensure that the currency stays in line with whatever currency they are pegged to.
The country and its central bank must ensure that the currency stays in line with whatever currency they are pegged to.
For example, back in 1998 Hong Kong entered a fixed exchange rate agreement. Today 7.75 Hong Kong dollars are equal to one US dollar. But the value of their currency is starting to change, so the central bank must quickly buy or trade its own currency to keep it at that 7.75:1 ratio. This is a very time-consuming task and requires the efforts of many professionals.
Potential conflicts with economic objectives
There may be times when a country needs to control economic objectives. Let’s say the value of the currency is falling, and the country needs to raise interest rates to stabilize the problem. Higher interest rates could negatively impact the fixed exchange rate, so the government has limits to what they can do while maintaining the fixed exchange rate.
Decrease in flexibility
Flexibility is limited when operating with a fixed exchange rate.
If the price of oil jumps overnight, and you’re in a country that imports oil, that also affects your country. However, when using a fixed exchange rate, there isn’t a way to minimize the existing account deficit in response to the increased price of oil.
Entering an agreement at the wrong rate
Pegging a currency only occurs when a country enters into an agreement.
Entering when the value of the currency is low tends to create worry for some countries. Values that are too high make the products that a country produces not competitive in the marketplace.
Keeping the value of the currency stable is time-consuming
Once entered into the agreement, the country is responsible for keeping its currency at the pegged rate. When the rate increases, they need to sell currency to lower it. And when the rate lowers, they need to buy currency to increase it. Keeping this balance requires a significant amount of time and resources.
A Few Examples
Many countries have decided that the benefits of a fixed exchange rate are worth the disadvantages. There are many countries that still participate, despite the fact that some countries — such as the United States — have migrated to a floating rates system.
Here are a few examples:
- Denmark — This country uses the krone, which is pegged at 7.46 against the euro since 1999.
- Hong Kong — This country uses the Hong Kong dollar, which is pegged at 7.75 against the US dollar since 1998.
- Chad — This African country pegged the Central African CFA franc against the euro at 655.957 in 1999.
- Ivory Coast — This country uses the West African CFA franc and pegged it against the euro in 1999 at 655.957 per single euro.
- Jordan — This country uses the dinar and pegged it at 0.709 against the US dollar in 1995.
The fixed exchange rate has provided stability for many countries, and that stability has provided much-needed predictability for trading partners and investors. Most countries peg their currency against the US dollar or the euro. However, as more countries move to a floating rates system it’s unknown what the future may have in store.
Looking to the Future
Currency plays an important role in the stability and prosperity of a country. Previous generations understood what could happen when a currency takes a sharp decline, and the dire consequences when it does. For example, in 1923, Germany experienced intense hyperinflation. The exchange rate between a US dollar and a German mark was one trillion marks to a single dollar. A literal wheelbarrow full of money couldn’t buy a single newspaper in the country of Germany.
The fixed exchange rate continues to be relevant, despite some countries (the US) moving away from it, especially for smaller countries that want to establish credibility with trading partners and investors.
A fixed exchange rate prevents these situations by pegging one currency to the value of another. It provides the ability to manage volatility, risk, and inflationary consequence while keeping the autonomy of local currencies. The fixed exchange rate continues to be relevant, despite some countries (the US) moving away from it, especially for smaller countries that want to establish credibility with trading partners and investors.
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