Advantages and Disadvantages of Currency Pegs
Advantages of Currency Pegs
Currency pegs have become extremely popular in the post Bretton Woods monetary world.
About one fourth of all countries in the world today have pegged their currencies to some
other major currency like the dollar or the euro.
This strategy has bankrupted certain nations like Argentina whereas it has caused other nations
like China to reach economic success. Therefore, this strategy has certain advantages as well as
certain disadvantages. In this article, we will list down both the advantages as well as
disadvantages.
1. Stable Basis for Planning: Currency pegs provide an extremely stable basis for financial
planning to the governments. Governments have to buy essential commodities such as oil
and food grains from the international market. Here, the government has to pay its
expenses in a foreign currency. Usually this foreign currency is the United States dollar
since it is the reserve currency of the world. However, other currencies like the Euro are
also accepted in the international market nowadays.
However, the issue remains the same regardless of whether the Dollar is used or the Euro.
The government has to convert its own currency to another one at the Forex market. If
the rates are constantly fluctuating, the government cannot anticipate how much of its
own currency will it require so that it can convert it to foreign currency and meet the
demand. On the other hand, currency pegs fix the rate and provide a stable basis for
governments to plan their revenues and expenditures in local currencies without any
concerns about the volatile rates.
2. Credible And Disciplined Monetary Policy: Currency pegs are often popular in third
world countries. Impoverished countries from South America, Asia and Africa have used
currency pegs in the past. This is because these impoverished countries are also breeding
grounds for corruption. Hence, these countries do not trust their local leaders with their
monetary policy. There is a big chance that the people that come to power may end up
causing hyperinflation. A case in point would be President Robert Mungabe from
Zimbabwe who basically destroyed the Zimbabwean currency for personal gain.
Hence, such countries want to outsource their monetary policy to a more developed
nation where the policymakers would take more responsible decisions. This only partially
offsets the threat of sabotage from local politicians. This is because politicians can still
order printing of money and cause inflation. However, they cannot reduce interest rates
and cause a bubble in the economy in general when a currency peg is being followed.
3. Reduced Volatility: Apart from the governments, the local businesses also face
advantages as a result of currency pegs. The local businesses can predict how their goods
will be priced in the international market. Once they are aware of the exact pricing, they
can also predict the quantities that will be demanded at that price. As such, they do not
face any volatility and can insulate themselves from foreign exchange losses. This puts
them at a major advantage as compared to other competitors who have to face such risks
and as such have to include a risk premium for the same in their prices.
Disadvantages of Currency Pegs
1. Increased Foreign Influence: On the flipside, countries which adopt a currency peg face
increased foreign influence in their domestic affairs. This is because their monetary
policy is determined by another nation. A lot of times, this leads to a conflict situation.
Consider the case of the attack on the Pound Sterling. During that time the British
government had pegged its currency to the German Deutschemark. German Bundesbank
increased the interest rates because of domestic concerns on inflation. The British wanted
the interest rates to fall. However, there was no drop in the rates. As such, the British
pound took a severe beating because the Bank of England was no longer in control of its
affairs and the Bundesbank had an increased influence in Britain’s domestic affairs.
2. Difficulty in Automatic Adjustment: A floating currency system leads to automatic
adjustment of deficits. For instance, if one country imports too much, they will have to
pay out a lot. This will lead to a decrease in the currency supply in their economy causing
deflation. Deflation means low prices and low prices make their exports competitive.
Hence, increasing imports automatically lead to a situation of increasing exports! The
freely floating system tends towards equilibrium. However, currency pegs tend to
exaggerate disequilibrium. Consider the case of the massive trade and current account
deficits between United States and China and the fact that at the root cause, they have
been caused by a peg between the dollar and the Yuan. Therefore, currencies that have
pegs with other currencies are prone to disequilibrium. This has happened several times
in the short economic history of freely floating currencies and is expected to happen
several more times in the future.
3. Speculative Attacks: Speculative attacks on a currency can only happen if it deviates too
much from its value. Freely floating currencies do not deviate too much from their value.
As soon as there is a deviation, the market mechanism sets in and correction happens
instantaneously. However, on the other hand, currency pegs can allow a huge difference
in the fundamental value of a currency and its market value. This is because the Central
Bank tries to artificially manipulate the value.
There are some financial funds with deep pockets that can even take on Central Banks
and such cases have happened several times. When currencies have ventured too far from
their fundamental value, speculators have been able to force devaluations on such
currencies. Also, sometimes the speculative attacks are so severe that countries have to
abandon the pegs and allow their currencies to freely float within a couple of days.
Whenever such an attack occurs, the common man of the country suffers increased losses
since foreign trade as well as foreign investments face a massive impact.
A currency which is already freely floating is at a much lower risk of such an attack.
Hence, this can be considered to be a major disadvantage of currency pegs.
Common Terminologies Used in Forex Markets
Financial markets have their own terminologies. The Forex market has a number of terms
which it shares with other financial markets but which mean different things in the Forex
market. Also, there are some words which are completely unique to Forex. In this article, we
have a closer look at Forex terms. These terms will be extensively used in other articles in this
module.
Base and Counter Currencies
In stock and bond markets one can sell their security. This means that they can convert their
security into money. However, in the Forex market, one is already buying and selling money. So
then how does the trading work?
Well, in the Forex markets, one buys and sells currencies simultaneously. This means that one
exchanges one form of currency for another. Therefore the prices of currencies are always
quoted in pairs. The price signifies the unit of the first currency that one is willing to pay for the
second currency. Since the price is always quoted in terms of the first currency, it is referred to
as the base currency. The other currency mentioned in the pair is the counter currency.
For example in a USD/EUR pair, the United States Dollar would be referred to as the base
currency while the Euro would be called the counter currency.
Long and Short Positions
Just like the bond and stock markets, Forex markets also allow traders to take long and short
positions. However, the meaning of long and short positions changes in this market. Once again
this is because currencies are traded in pair. Hence, new investors get confused what happens
when they go long and what does it mean to go short.
In the Forex market going long means that you buy units of the base currency and sell units of
the counter currency. When one already has a long position and continues to go long, they are
said to be going longer!
For example if you were to go long on the USD/EUR pair, you would have to buy the USD and
sell EUR in the market.
Similarly, in the Forex market going short means that you sell units of the base currency while
buying units of the counter currency. Adding to the short position is referred to as going shorter
Therefore if you were to go short on the USD/EUR pair, you would have to sell the USD while
simultaneously buying the EUR.
Also, going back to a zero position from a long or short position is referred to as squaring off. If
you are long, you need to sell to square off whereas if you are short, you need to buy to square
off.
Bid, Ask and Spread
Forex markets are run by market makers. They provide a two way market for all currencies at all
times. Therefore, they provide buy and sell quotes. The price at which they are willing to buy is
always less than the price at which they are willing to sell. The difference is meant to
compensate them for the risk they are taking by holding a volatile asset for an uncertain period of
time.
The price at which they are willing to buy is called the bid price whereas the price at which they
are willing to sell is called the ask price. The difference between the two is called the bid ask
spread or sometimes it is simply referred to as the “spread”.
Lots
This term is frequently used when Forex markets derivatives are being traded. Forex market
future contracts always have a fixed size. For instance, US dollar contracts may be available in
multiples of $5000. Therefore every $5000 contract will be referred to as a lot. Hence, if you
wish to buy USD 25,000 in the future, you will have to purchase 5 lots. Different currencies have
different lot sizes available. Market makers provide more flexibility to currencies which have
higher liquidity.
Pip
This is the minimum amount by which the currency quote can move. The usual pip refers to
1/10000 of the quoted currency. This means that a currency must change by at least 0.00001%
for there to be an effect on the quoted prices in the Forex markets.
Pips have become a part of the Forex trader lingo. Changes in prices and even profits made are
expressed in terms of pips. However, since the pip could refer to a variable amount of money, it
takes some experience to understand what is being communicated.
Value Dates and Rollovers
Value date is the date at which the parties to the trade agree to settle their accounts. This means
that the open positions of all derivative contracts are closed automatically on the value date. Thus
contracts become more volatile when they are closer to the value date.
Also, in many cases, traders decide to rollover their contracts. This means that they decide to
settle their contracts on the next value date instead of the current value date. In order to do so,
both parties must agree and then also there has to be a fees paid based on the interest rate
differences of both the currencies.
There are many more terms that are frequently used in the Forex market. However, those terms
may refer to strategies used in the market and are therefore beyond the scope of this basic article.
To sum it up, Forex trading has its own vocabulary which one must get used to.
