Pegged exchange rates: The pros and cons

In June 2010, China's government decided to end a 23-month peg of its currency to the U.S. dollar. The announcement, which followed months of commentary and criticism from United States politicians, was praised by global economic leaders. But what prompted the long-awaited move? (For background reading, see "Why China's Currency Tangos With the USD.")

China's economic boom over the last decade has reshaped its own country and the world. Once known for Communist rule and isolationist policies, China has changed gears and become a global economic powerhouse. This pace of growth required a change in the monetary policy in order to handle certain aspects of the economy effectively – in particular, export trade and consumer price inflation. But none of the country's growth rates could have been established without a fixed, or pegged, U.S. dollar exchange rate.

And China's not the only one that has used this strategy. Economies big and small favor this type of exchange rate for several reasons. Let's take a look at some of its advantages – and drawbacks.

TUTORIAL: Currency Trading

Countries prefer a fixed exchange rate regime for the purposes of export and trade. By controlling its domestic currency a country can – and will more often than not – keep its exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad. For example, let's assume a euro (EUR)/Vietnamese dong (VND) exchange rate. Given that the euro is much stronger than the Vietnamese currency, a T-shirt can cost a company five times more to manufacture in a European Union country, compared to Vietnam.

But the real advantage is seen in trade relationships between countries with low costs of production (like Thailand and Vietnam) and economies with stronger comparative currencies (the United States and the European Union). When Chinese and Vietnamese manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit that is made through the exchange rate. So, keeping the exchange rate low ensures a domestic product's competitiveness abroad and profitability at home. (For more insight, check out "Currency Exchange: Floating Versus Fixed.")

The fixed exchange rate dynamic not only adds to a company's earnings outlook, it also supports a rising standard of living and overall economic growth. But that's not all. Governments that have sided with the idea of a fixed, or pegged, exchange rate are looking to protect their domestic economies. Foreign exchange swings have been known to adversely affect an economy and its growth outlook. And, by shielding the domestic currency from volatile swings, governments can reduce the likelihood of a currency crisis.

After a short couple of years with a semi-floated currency, China decided during the global financial crisis of 2008 to revert back to a fixed exchange rate regime. The decision helped the Chinese economy to emerge two years later relatively unscathed. Meanwhile, other global industrialized economies that didn't have such a policy turned lower before rebounding.

Is there any downside to a fixed currency? Yes. There is a price that governments pay when implementing the pegged-currency policy in their countries.

A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves, as the country's government or central bank is constantly buying or selling the domestic currency. China is a perfect example. Before repealing the fixed rate scheme in 2010, Chinese foreign exchange reserves grew significantly each year in order to maintain the U.S. dollar peg rate. The pace of growth in reserves was so rapid it took China only a couple of years to overshadow Japan's foreign exchange reserves. As of January 2011, it was announced that Beijing owned $2.8 trillion in reserves – more than double that of Japan at the time. (To learn more, check out "How Do Central Banks Acquire Currency Reserves and How Much Are They Required to Hold?)

The problem with huge currency reserves is that the massive amount of funds or capital that is being created can create unwanted economic side effects – namely higher inflation. The more currency reserves there are, the bigger the monetary supply – causing prices to rise. Rising prices can cause havoc for countries that are looking to keep things stable. As of December 2010, China's consumer price inflation had moved to around 5%. (Learn more about inflation in our Inflation Tutorial.)

These types of economic elements have caused many fixed exchange rate regimes to fail. Although these economies are able to defend themselves against adverse global situations, they tend to be exposed domestically. Many times, indecision about adjusting the peg for an economy's currency can be coupled with the inability to defend the underlying fixed rate.

The Thai baht was one such currency.

The baht was at one time pegged to the U.S. dollar. Once considered a prized currency investment, the Thai baht came under attack following adverse capital market events during 1996-1997. The currency depreciated and the baht plunged rapidly, because the government was unwilling and unable to defend the baht peg using limited reserves.

In July 1997, the Thai government was forced into floating the currency before accepting an International Monetary Fund bailout. Even so, between July of 1997 and October 1997, the baht fell by as much as 40%. (For more about currencies under attack, check out "The Greatest Currency Trades Ever Made.")

Given both pros and cons of a fixed exchange rate regime, one can see why both major and minor economies favor such a policy choice. By pegging its currency, a country can gain comparative trading advantages while protecting its own economic interests. However, these advantages also come at a price. Ultimately, however, the currency peg is a policy measure that can be used by any nation and will always remain a viable option.