A fixed or pegged currency is one where the currency’s value is matched to that of another asset. The asset may be a single currency, or it may be a basket. The fixed rate will be determined by central banks, and will be defended and maintained in order to protect economic stability. In this article we’ll first go through advantages and disadvantages with pegging a currency, then we’ll give you strategies for how you can profit on trading pegged currencies, and finally we’ll discuss real cases in the form of the Saudi Riyal and the Danish Krone.
Why do central banks peg currencies?
Fixed exchange rate mechanisms can be introduced for a number of reasons, and offer a number of advantages or disadvantages for the economy of the nation which utilizes them. A pegged currency can be very useful in combating inflation in an environment where the public has lost confidence in the nation’s economic policies, and prices keep rising uncontrollably as a result. The peso was pegged to the US dollar by Carlos Menem to stop rampant inflation in 90’s Argentine. It may be temporarily introduced to protect an economy from currency volatility that is caused by speculators or event shocks.
In response to the Asian Crisis of 1998, and speculator attacks, Malaysia had to keep the ringgit pegged to the dollar for seven years. Another reason for maintaining a fixed currency is to defend the profits of exporters in a nation against normal currency fluctuations which make predictions difficult. Hong Kong was one of the nations that maintained such a peg until 2008. Since then the currency floats in a band. A peg may be implemented to facilitate convergence between the financial systems of two nations where increased cooperation, or even ultimate merger is desired. This has been the case in Denmark, and various small Balkan nations which aspire to join the Euro eventually. Finally, the peg may be maintained for political reasons and this is the case with most Gulf Arab States.
What are the advantages of pegging a currency?
The advantages of the fixed exchange rate system are born of its clarity and simplicity. By pegging the currency, the central bank of the nation is declaring its intention to limit its expansion of the money supply by adhering to policies of the other, more credible central bank. It gives up its independence in setting policy rates and following its own currency policies in response to domestic needs, but in return gains the ability to rapidly suppress inflation expectations that are otherwise uncontrollable. Usually, the central bank of a fixed currency will change its interest rate policy on the same day, and in the same percentage value of the controlling central bank. If they had not done so, arbitrageurs in the market would quickly exploit the situation, quickly making the fixed exchange regime untenable.
What are the problems with pegged currencies?
The problems with fixed exchange rate systems arise out of the inability of the system to adapt to changing conditions. For instance, a currency peg adopted at a time when the nation possessed ample forex reserves is unlikely to function well when the current account surplus evaporates and all that defends the rate is the intervention promise of the central bank. Market participants are unlikely to regard such a promise seriously, and this lack of credibility has the potential to create currency crises, once speculators force authorities to make good on their promises.
A floating exchange rate system allows the currency to adapt to changes gradually, and removes the rationale behind currency crises. A fixed exchange system doesn’t react to changes, and unless the authorities eventually readjust the exchange rate through a process known as devaluation.
There are a number of ways of trading a fixed currency regime:
From time to time, authorities behind fixed currency regimes corner themselves into impossible situations through complacency and incompetence. During the 1998 Asian crises a number of fixed currency regimes were attacked by speculators who wanted to force the hand of the Asian central banks which were constrained by large current account deficits. The results were catastrophic. Between 1980 and 2000 many nations in the world went through similar phases, in almost every case national economies were severely mauled, while the currency lost much of its credibility as a result of the turmoil. Nowadays complete currency collapses are rarer partly because of the increased efficiency of international organizations, and partly because many developing nations avoid the economic model based on large deficits and short term money inflows.
Exploiting a currency crisis will usually require two separate phases of economic analysis. First the trader must be aware of the currency reserves of the nation’s central bank. Is the nation running a current account surplus or deficit? How many months of import need is met by forex reserves? Second, once the crisis begins, he must keep an eye on the size of the nation’s interventions, and on how rapidly they erode the central banks reserves. In some cases, authorities will remain blind to the dangers posed by dwindling reserves right up to the last minute. In other cases, they will coordinate and support their interventions with attempts to secure international aid in medium to long term capital infusions from the IMF, or regional economic powers. During the recent collapse of the Icelandic krona, for instance, Iceland’s central bank was bailed out by the other major Central Banks of Scandinavia. In contrast, when Pakistan was unable to obtain similar backing from its ally China, its only recourse was the IMF.
The best course for exploiting a crisis is to be always one step ahead of the market in examining and studying the crisis-prone nation’s fundamentals. If this is not achievable, the shorted currency must be held until some kind of government intervention, either through higher interest rates, or by direct external funding agreements, signals the end of the crisis. Since currency crises usually entail high volatility, the retail trader must also be careful not to be euphoric about his profit potential. On the other hand, collapsing currencies have no bottom, and enormous profits can be made until intervention, or the imposition of capital controls brings calm back to the market.
Trading currency interventions
The opportunities for this strategy are far more frequent than the other scenario, highly tradable, and very lucrative, with very little risk indeed. In this case the central bank has the stated intention to intervene in order smooth currency fluctuations, and also the power and credibility ensured by large foreign exchange reserves. Since intervention in case of currency fluctuations is a certainty, the trader is offered profits at almost no risk. By staying calm in response to market rumors and panic, and siding with powerful and credible government authorities the trader acts in a contrarian manner, and entrusts a part of the task of risk management to the central bank authorities of the intervening nation.
The main problem in trading pegged currencies on this basis is the small size of the fluctuations that we wish to trade, and the small number of forex brokers offering them. Apart from that, a relatively small bid-ask spread is a necessity, because we don’t want our profits to be negated by the costs that the broker is charging us. It is important to be patient, and perhaps to maintain a limit order at all times, so that we will be able to capture the very brief but profitable disruptions the fixed rate system will go through. When these fluctuations occur, the trader will buy or sell the fixed currency in harmony with the central banks policies and declarations.
In light of the above descriptions we will examine two currency pairs, and discuss some hypothetical scenarios for trading them.
The Saudi Riyal has been pegged to the US dollar for decades, and the peg plays a useful role in both controlling inflation in the Saudi economy, and also in ensuring Saudi Arabia a powerful friend who will protect its independence and security. As the justification behind this peg is political, and for the most part not economic, it is highly improbable to break down as long as the United States maintains its position as a global superpower, and the Saud family holds the reins of power in Riyadh. Thus, the trader can enter positions in this currency with relatively high leverage and with little fear of destructive volatility.
From time to time the usd/sar pair makes movements in response to market rumors about Saudi Arabia abandoning the peg outright, or replacing it with the currency of the proposed Gulf economic Union. In the long term, it is almost a certainty that Saudi Arabia will be a part of such a union, and will eventually drop its peg in alignment with some other Gulf states who have already done so. But when they do this, it is also certain that the decision will not be made public through rumor mills or hearsay, but through a press conference along with much fanfare and celebration. And naturally, the events of autumn-winter 2008 have delayed this decision even further. In short, the Gulf pegs are not likely to go anywhere anytime soon, and the volatility of the riyal offers safe and profitable opportunities for the trader who can find those brokers who offers the currency. Trading the riyal should be done in accordance with the guidelines established in item two of the above.
The Danish Nationalbanken has no money supply, or interest rate target, and its sole purpose is keeping the krone pegged to the Euro. The crown is pegged to the euro in a 2.25 percent band around a central rate of 7.46038 in the ERM-2 grid. ERM (the European exchange rate mechanism) was set up in 1979 to facilitate the eventual adoption of the Euro by the members of the European Common Market, and with the launch of the Euro in 1999 it was replaced by the ERM-II. The ERM II stipulates that the currency fluctuations in EUR/DKK remain within a band of 2.25 percent either side to the central value of approximately 7.46.
The behavior of the Danish Central Bank is very predictable, and their open and credible intervention policy has kept the rate within a band of 1 percent during the period that the ERM II has been in operation. As the ERM II also guarantees unlimited support by the ECB in case of a severe dislocation in the currency market, the Danish currency is almost certain to be maintained within this period for the foreseeable future.
Traders have been using the fluctuations and volatility in the EUR/DKK for quite a while, and at least in the past ten years there hasn’t been an occurrence that would make us seriously consider the reliability of the agreements between the ECB and the Nationalbanken. The indications are that the Danes will join the Euro at some point in time, but till then, the beginning trader can practice his skills in this tame and easy-to-trade pair.