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MACROECONOMICS
(Pegged Currency)

By:
Akash Anil Kamat
(16B103)
Tushar Abhyankar
(16B120)
Yash Verma (16B121)

Contents
1. Introduction............................................................................................................ 3
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1.1. What is Pegging?............................................................................................. 3
1.1.1. Example of the U.S. Dollar.........................................................................3
2. Why do countries peg their currencies?.................................................................3
2.1. List of countries that have pegged their currencies.........................................4
3. Advantages of Pegging Currency...........................................................................4
Increase in Exports and Trade..........................................................................4
Lower Cost of Production................................................................................. 5
Increase in Profitability.................................................................................... 5
Rising standard of living and Economic Growth...............................................5
Protection against currency fluctuations..........................................................5
4. Disadvantages of Pegging Currency.......................................................................5
Need to maintain large reserves......................................................................5
Higher Inflation................................................................................................ 5
Economies may fail.......................................................................................... 5
Other Disadvantages:...................................................................................... 5
5. Examples of Impact of having Pegged Currency....................................................6
5.1. Mexico.............................................................................................................. 6
5.2. Argentine Peso- Adverse Effect........................................................................6
5.3. Hong Kong....................................................................................................... 6
6. References............................................................................................................. 6
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1. Introduction
1.1. What is Pegging?
Pegging or a currency peg is a policy of exchange-rate, implemented by a country
or government. It involves pegging or attaching another country's currency to its
central bank's rate of exchange. Hence it is also referred to as a pegged exchange
rate or a fixed exchange rate. Countries usually peg their currencies to other
countries currency, most popular being the U.S. Dollar or the Euro. That means
the central bank of the country has the intention of controlling the value of its
home currency such that its actual variation mimics the variation of the U.S.
Dollar or Euro.
Currency peg helps exporters and importers to create a steady trading
environment. They know precisely what the exchange rate would be, thereby
limiting effects of uncertainties like interest rates or inflation which could hinder
dealings between countries. However, to sustain the peg, the country must store
lots of foreign currency in hand. Hence most of the countries that peg their
currencies to another countrys currency export a lot to that country. Their
companies receive payments in the foreign currency. They then exchange this
foreign currency for home / local currency in order to compensate their employees
/ workers and their domestic suppliers.

1.1.1. Example of the U.S. Dollar

Central banks, to whom these companies sell the foreign currency (example
U.S. Dollars), usually use the foreign currency to purchase U.S. Treasuries. By
doing so, they attempt to receive some interest on their U.S. Dollar holdings. If
they require to raise domestic currency to pay their companies, they then sell
the U.S. Treasuries in the secondary market.
The Finance Minister of a country, monitors the currency exchange rate of
his/her country, relative to the U.S. Dollar's value. If the currency falls below
the peg, he/she needs to raise its value and lower the U.S. Dollar's value. This
is done by selling U.S. Treasuries, putting more of them on the secondary
market. The cash received is used to purchase local currency. This increases
the supply of U.S. Treasuries, thereby lowering their value. This then lowers the
value of the U.S. Dollar and reduces the supply of domestic currency,
increasing its value and hence restoring the peg.
However, keeping an exact amount is difficult, since the U.S. Dollar's value
changes continuously. Hence some countries peg their currency's exchange
rate to a range of U.S. Dollar, instead of an exact value.

2. Why do countries peg their currencies?

Pegging is done by countries majorly to maintain competitiveness of their exports.
It means the countrys central bank controls the value of the currency in a way
such that it rises and falls in accordance to the currency to which it is pegged. A
weaker currency is good for exports and tourism, as it becomes cheaper for
people buying goods in the foreign markets where it is exported and also cheaper
for the tourist who arrive in these countries as tourists.

It is advantageous for small nations which generally peg their currencies to the
U.S. dollar or the Euro. The pegged strategy helps stabilize and secure small
economies which would otherwise be unable to withstand the volatility.
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Conversely, if a large and growing economy like India maintains a fixed currency
policy, it would result in an oversized need to buy more and more dollars/euro to
maintain the proper ratio.

The countries that have pegged to the dollar in the Caribbean island like
Bahamas, Bermuda and Barbados have done so because their main source of
income is payments made by the tourists in U.S. dollars. This stabilizes their
economy and makes them less volatile. There are many countries in the Middle
East including Oman, Saudi Arabia and UAE that have pegged their currency to
the U.S. dollar as these oil-rich nations need the U.S. as a major trading partner
for oil. These countries make sure that value of their currency remains stable and
are not impacted by constant change as in the case of floating exchange rate,
when they participate in International trade.

De-pegging is a risk that is faced by the currencies that are pegged. De-pegging is
the removal of a previously existing peg on a currency. De-pegging is done if the
central bank is unable to sustain the peg or if the pegging has caused huge
inflation. In 2015, the Government of Switzerland ended its peg to the Euro with
the Swiss Franc. This resulted in taking the Franc to higher exchange rates against
the Euro and other currencies.

2.1. List of countries that have pegged their currencies

10 major currencies pegged are

Peg
Country Region Curr. Name Code Peg Rate Rate Since
Curr.
Bahrain Middle East Dinar BHD 0.376 U.S.D 2001
Bulgaria Europe Lev BGN 1.95583 EUR 2002
Central Convertible
Cuba CUC 1 U.S.D 2011
America Peso
Denmark Europe Krone DKK 7.46038 EUR 1999

Hong Kong Asia Dollar HKD 7.75-7.85 U.S.D 1998

Nepal Asia Rupee NPR 1.6 INR 1993

West African
Niger Africa XOF 655.957 EUR 1999
CFA Franc

Oman Middle East Rial OMR 0.3845 U.S.D 1986

Central
Panama Balboa PAB 1 U.S.D 1904
America

Qatar Middle East Riyal QAR 3.64 U.S.D 2001

Saudi
Middle East Riyal SAR 3.75 U.S.D 2003
Arabia

United Arab
Middle East Dirham AED 3.6725 U.S.D 1997
Emirates

South
Venezuela Bolivar VEB 6.3 U.S.D 2013
America
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3. Advantages of Pegging Currency

Increase in Exports and Trade
Having a fixed/ pegged exchange rate is advantageous for increasing the
countrys exports and indirectly its trade relations with the other country. This
is possible by keeping its exchange rate at a lower level than the other
country. Keeping a lower exchange rate would make the countrys goods more
competitive and helpful for improving the exports.

Lower Cost of Production

Keeping the countrys currency at a lower level has one more advantage. This
will not only make the goods competitive but will also make the goods cheaper
for foreign buyers. This is because cost of producing in home country is much
less than the cost it would take to produce the same good in the foreign
country.

Increase in Profitability
If the countrys goods are more competitive, it will result in more demand from
foreign countries. More demand will result in more exports and then in higher
profitability. One more contributor to profitability is lower cost of production. If
your cost is lower it is obvious that your bottom line would be higher.

Rising standard of living and Economic Growth

Pegged exchange rate increases a companys earnings outlook as seen above.
As there will be many such companies having increased output and profits, this
will benefit the country as a whole. This will increase overall employment and
standard of living of the people. This will have an overall effect on the
economic growth in the country.

Protection against currency fluctuations

A pegged/ fixed exchange rate regime will protect the country from
fluctuations in the forex markets. Currency fluctuations are one of the factors
responsible for business cycles. If the countrys currency depreciates too much
it will have an adverse effect on the overall economy. Thus, pegging helps such
countries.

4. Disadvantages of Pegging Currency

Need to maintain large reserves
As the countries have to counterbalance the effect of appreciation or
depreciation of currency through buying or selling foreign currency, it is
essential to maintain high reserves at every point of time. Maintaining such
high reserves may prove difficult for such countries.

Higher Inflation
As more reserves are required to be maintained, the overall money supply in
the country increases. To create equilibrium, demand for money increases.
Thus, this results in the overall price level to rise i.e. inflation. E.g. Chinese CPI
increased to 5% in December 2010.

Economies may fail

Higher inflation may result in negative economic growth and depression in the
economy. This may further result in the economy to crumble. E.g. Thai Baht
pegged with USD, was completely exposed during 1996-97 due to adverse
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market conditions. It fell by nearly 40% and Thai government had to bailout at
IMF.

Other Disadvantages:
Based on Mundell-Fleming model, if a country tightens its monetary policy,
interest rates rise causing foreign investors to invest largely, thereby causing
surplus in Balance of Payments. In order to maintain the peg, the central bank
buys foreign money in exchange for domestic money, causing home money
stock to increase. Hence the original monetary contraction gets reversed and
interest rates are pushed back to initial rates. Hence a domestic monetary
policy cannot be used to implement macroeconomic stability in case of
countries with pegged currency
While some small countries peg their currencies to a larger countrys to create
stability, doing so exposes their currency to the same risks the larger country
faces.

5. Examples of Impact of having Pegged Currency

5.1. Mexico
Suppose a country like Mexico wants to peg its currency to that of the United
States. This means Pesos value will move at the same rate as the U.S. Dollar. If
the Peso falls compared to U.S. Dollar, Mexico can utilize its foreign reserves,
example Euros, to buy Pesos and remove them from the market. This causes
shortage of Pesos, increasing its demand, and thereby its value. Similarly, Mexico
can sell Pesos when their value increases compared to the U.S Dollar, to increase
the availability of Pesos till their value falls to match the dollar.

5.2. Argentine Peso- Adverse Effect

In April 1991, Argentina adopted a peg against the US Dollar. The Central Bank of
Argentina decided to have a hard peg by converting pesos into dollars.
In the wake of a government debt default, Argentina failed to defend its peg in
2002, and the currency declined by 75% in 6 months. Given that the bulk of
Argentinas $100 billion of debt was dollar denominated, the collapse of the peso
made it harder for the Argentine government to repay the debt as it suddenly
required far more pesos to repay the same amount of US dollar debt. Argentina
defaulted.

5.3. Hong Kong

The Peoples Republic of China resumed sovereignty over Hong Kong Special
Administrative Region (Hong Kong SAR) on July 1, 1997. In 1997, Hong Kongs
Financial Secretary Donald Tsang sold the U.S. dollar FX reserves of Hong Kong,
bought Hong Kong dollars and invested them on the Hong Kong stock exchange,
making a fortune for government coffers (small box for holding valuables) and
successfully warding off speculators. If we look at the chart of Hong Kongs FX
reserves over this period, we can see the resulting unusual spike in Hong Kongs FX
reserves from his successful action.
The official exchange rate is set at HK$7.80 per U.S. dollar. Issuance and redemption
of banknotes issued by NIBs, is done against U.S. dollars at the official exchange rate
of HK$7.80 per U.S. dollar. Issuance and withdrawal of government-issued notes and
coins are also settled against U.S. dollars at the exchange rate.
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6. References
1. http://www.investopedia.com/terms/c/currency-peg.asp
2. http://www.investopedia.com/video/play/how-does-currency-peg-work
3. https://www.thebalance.com/what-is-a-peg-to-the-dollar-3305925
4. Bloomberg