Fixed vs. Pegged Exchange Rates
The rate at which one banknote can be converted into another.
Exchange rates are the rate at which one banknote can be converted into another. The "conversion" is using one banknote (base) to buy another (quote). For example, if one US Dollar can buy 0.95 Euros (per USD), theis 0.95 EUR/USD for the dollar holder and 1.053USD/EUR for the Euro holder.
Each currency has a three-letter acronym used to identify them. People can compare their value and see conversion cost trends with a simple google search. Here are some examples of these acronyms:
- Japanese Yen (JPY)
- Euro (EUR)
- Chinese Yuan/RenMinBi (CNY)
- Switzerland Franc (CHF)
- Central African Franc (XAF)
It's important to double-check the name of the currency being converted, especially if the country in question is close to an economic union. For example, a Central African Franc is useless in Bora Bora, and Euros will get you further in Italy than in Switzerland.
These rates are important to tourists, investors, multinational corporations, hedge funds, and export-oriented industries.
Changes in the value of one currency relative to another are known as fluctuations. When the base currency buys more of the quote currency than before, it is said to have become more robust or "appreciated." Consequently, i.e., it buys less of the quote currency, and it is said to have "depreciated."
Note that "depreciation" isn't necessarily bad, and "appreciation" isn't necessarily good.
As a general rule, currency value changes can significantly distort investment returns.
Suppose an American invests a tidy sum in France and earns a 7% return on their investment (using Euros, of course). That doesn't look like a lot now. But wait, if we assume that the Euro appreciated 5% over the same period, the investor has bagged a 12.35% profit on this trade. Impressive, isn't it?
As a result, the exchange rate can affect an investor's decision when investing abroad.
These rates are affected by many factors in the domestic and global economies.depreciates a currency over time. High demand for a country's exports creates demand for the notes used there, which leads to an increase in the value of its currency.
How do you calculate exchange rates?
The formula to calculate exchange rates is as follows:
Amount of Currency Given/ Amount of Currency Received
Expanding on the earlier example, if someone received €95 in exchange for $100, the rate would be:
$100 given/€95 received = $1.05 per Euro
If a Eurozone citizen is visiting the US and converts their money, they would do the opposite:
€95 given /$100 received = €0.95 per US Dollar
Alternatively, someone might know the exchange rate and how much domestic money they have on hand, but not how much they should receive in return. In that case, use the following formula:
Amount of Currency in hand/ Exchange Rate
The rate used should represent starting currency per unit of the desired currency. For the American tourist converting to Euros, that would be:
$100 in hand/$1.05 per Euro = €95 received
Nowadays, most credit cards can handle the conversion on behalf of the cardholder. Some people think they shouldn't exchange cash when purchasing from foreign merchants, but that isn't always the case.
Many cards charge for the currency conversion itself and then add a foreign transaction fee, which varies between companies. On the other hand, some cards waive it altogether. Business owners and purchasing departments should be mindful of this fact.
Vendors sometimes engage in dynamic currency conversion (DCC). The vendor chooses the rate and converts the payment into the purchaser's currency before charging your card. This can be more expensive, and the foreign transaction fee may still apply.
Investors and businesses may try to overcome volatility in foreign exchange markets by securing a forward exchange rate with a financial institution that agrees to conduct the conversion at a certain speed in the future.
What are fixed exchange rates?
In a fixed-rate system, the amount of foreign money received per unit of domestic capital is constant. This is what differentiates it from a peg. As a rule of thumb, fixed rates are stricter than pegged ones and limit the's action more.
The country maintains a constant rate of exchange with the help of its monetary policies. Its bank holds sizeable foreign currency reserves and only issues notes against them to hold their value steady concerning the foreign currency.
In such situations, the central bank has little maneuverability to address domestic economic issues because doing so affects factors that influence conversion costs. For example, interest rates affect demand and inflation, affecting the legal tender.
However, some fixed systems are even more direct, where some nations have adopted another country's money as their legal tender. An example is the BritishIslands which has adopted the US Dollar.
This process is "formal dollarization" and is used by some small tourist-driven economies to make travel easier for visitors. When a country forfeits having a legal tender to adopt another nation's currency, that is "currency substitution."
Currency unions arise when multiple nations share a legal tender, the Eurozone being an obvious example. The conversion cost is "specified" as one Euro in Italy equals one Euro in Greece.
These unions will sometimes agree to fix their currency to another one. For example, the island nations using the Central Pacific Franc (CPF) have maintained the CPF at 0.0084 EUR since June 2020.
A particular type of fix is the currency board, where the domestic currency is tied to that of another more prominent country. Additionally, the ability to convert money is guaranteed, and the board is backed by law.
The IMF may recommend currency board programs to nations struggling to stabilize their economies and lend credibility to their banknotes.
What have pegged exchange rates?
Like fixed regimes, pegged regimes are also used to maintain a particular conversion cost. The significant difference is that pegged rates have some wiggle room and can change over time. As a result, pegs allow central banks more flexibility than fixed conversions.
Like the other exchange rates, central banks tasked with supporting a peg will buy and sell foreign currency reserves and issue currency. Because pegs aim to keep forex purchasing costs within certain limits, the central bank can take minor actions on economic issues whenever required.
The CPF to EUR 0.0084 conversion rate was introduced in the previous segment. Therefore, if the CPF nations allowed the conversion rate to vary between 0.008 - 0.009 EUR, the nations using the CPF would be enacting a currency band.
The People's Bank of China uses a crawling band (or crawling peg) system, which is like a regular currency band. The central bank allows the CNY to trade in a 2% fluctuation range from a certain point.
Every day the PBOC chooses a rate against the USD based on the yuan's previous performance and forex markets for China's major trade partners. Hence the band system "crawls" because it can change over time.
Pegging was widespread between 1958 and 1971 until Nixon did away with the gold standard and allowed USD to float. During that period, nations attempted to maintain a peg to the USD within a 1% band.
This was the "Bretton Woods" system, named after the July 1944 conference in Bretton Woods, New Hampshire. Delegates from Allied nations gathered to create a new international monetary system.
One of the significant outcomes of the Bretton Woods conference was a system that pegged foreign notes to the US dollar, with the value of $35 fixed to one ounce of gold.
What are floating exchange rates?
To address domestic inflation and a trade imbalance, Nixon ended the gold standard in 1971.
Attempts to recreate the Bretton Woods system failed, and within a few years, the USD and many currencies linked to it began to "float."
What does it mean if a currency "floats"? Simply put, the value of one nation's banknotes relative to another's is determined by the forex market and domestic economic conditions. As a result, the exchange rate can move freely.
As a result, floating regimes tend to have the most efficient distribution of forex and capital investment. As a result, their currencies are at less risk of being over or under-valued, which makes them relatively safe as long as the domestic economy is stable and the country follows a sound economic policy.
When the central bank doesn't have to issue notes against its reserves (to hold the banknote at a particular value), it is free to take measures to control inflation and combat unemployment.
The central bank may intervene only to smooth extreme fluctuations.
Some central banks, such as the US Federal Reserve, don't intervene at all. The Federal Reserve allows a "clean float" and lets market forces determine USD values.
A "clean float" is sometimes referred to as a "pure exchange" or "free-floating" rate. Many countries which face very different circumstances use this free-market approach:
- European Union
When central banks intervene to stop the currency value from changing, that would negatively impact the domestic economy; the nation is engaged in a "managed float" or "dirty float" regime.
Generally, a "managed float" is when government legislation mandates central banks to intervene in currency prices, including keeping them within a specific range or band.
That may sound a lot like the crawling peg system employed by China. Other countries, including Nicaragua and Botswana, also use a crawling peg. Some nations adjust more or less often - for example, Nicaragua adjusts the peg every few years.
A crawling peg is a managed float, but not all managed floats are crawling pegs. For example, India and Singapore also use managed floats that aren't classified as crawling pegs.
An important note on forex terminology
Exchange rate regimes fall on a spectrum. They can be hard to understand without context. Moreover, many institutions and firms in the finance industry use different terms.
When "fixed" is used, it usually contrasts with "floating" regimes. This indicates that the government is asking the central bank to intervene in the currency's value.
Domestic law requires the central bank to maintain a specific rate, which is a primary fixing indicator.
"Hard peg" and "soft peg" are two other confusing terms. Recall that the conversion cost maintained is often called a peg. Even though the CFP is 0.0084 EUR and not allowed to vary, that number is still called a "peg."
The CFP is a "hard peg." With its 2% variation band, the CNY is a "soft peg." "Hard peg" refers to stricter fixed rates, while "soft peg" refers to pegged rates.
"Soft pegs" have room for minor fluctuation and may be adjusted daily, weekly, or monthly. "Hard pegs" stay the same.
Note that the system used to manage the CNY, the crawling band or crawling peg, is also referred to as a "managed float."
While the CNY can vary, the People's Bank of China (PBOC) intervenes once it exceeds a particular upper or lower limit.
Hence, the term "managed float" is used in contrast to completely "free-floating" currencies. In "free floats," banks don't intervene under any circumstances.
The best way to understand the currency regime used by a country is to do some basic research. Searching for the currency's history or relevant policy is a good starting point.
It is essential to fully understand and describe how the country's central bank treats the value of its banknotes.
Floating vs. Fixed vs. Pegged Exchange Rates
Is a fixed, pegged, or floating exchange rate better?
Each system has its strengths and weaknesses. Fixed exchange rates make transactions between two countries much more accessible. They cut some of the guesswork involved in estimating costs and returns.
For example, if an investor earns an 8% return in the US from a country with a fixed rate, their actual return in their home currency is 8%.
Currency unions or adopting another nation's currency are even more direct methods. They further increase ease of business.
For any peg, the country in question is exposed to positive and negative economic trends from their connected economies. This is because they use the same money supply - if the US experiences inflation, so will the British Virgin Islands.
One way to combat this risk is diversifying is using a currency basket. For example, Morocco pegs its Dirham to a basket weighted 60% to the EUR and 40% to the USD.
Some nations also fix or peg their currency to increase its credibility and stabilize the local economy. For example, currency boards have been used to overcome inflation.
With both exchange rates, nations can make their exports more attractive by devaluing their currency.
Doing so decreases the price of their exports to foreign consumers. As a result, the foreign banknote buys more of the local banknote, a significant benefit to nations reliant on exports for growth, such as Hong Kong.
Pegging also allows more variation in the exchange rate. As a result, countries don't have to be relatively as hawkish as with fixed regimes. Nonetheless, monetary policy is mainly used to defend the peg.
But holding one out of the two exchange rates isn't easy and requires a lot of forex reserves - sometimes more than what a central bank possesses.
In that case, a "currency crisis" results as people holding the currency doubt its usefulness, leading to a massive sell-off and a heavy depreciation in its value.
It is followed by rampant inflation and a host of negative consequences. Vital exports become more expensive. Spooked investors dump the banknote and local investments.
Floating regimes, especially clean floats, reduce the need for large forex reserves. The system also frees the central bank to pursue macroeconomic policies with domestic benefits.
But floating exchange rates are much more volatile and introduce forex risk into transactions between countries. Forex risk is uncertainty due to changing currency values. Like with a peg failure, these effects can quickly spread through the domestic economy.