Pegged Exchange Rate

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 [Page 1272]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).

With its foreign currency reserves and controls on convertibility, China successfully pegged the yuan to the dollar 1994–2005.

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.

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