If a currency of one nation is pegged to another, what are the implications of this? Presumably, the coattail nation has control over it’s money supply. Just because they say their currency is worth a dollar or a euro or a deutsch mark or whatever, doesn’t make it so, does it (except at official exchanges)? How do they deal with debt?
Thanks,
Rob
As I understand it the government either buys and sells their own currency with foreign currency reserves to maintain the peg or they simply make it illegal to trade in foreign currencies (which obviously leads to big black market problems).
Also, I think at least theoretically a nation with a pegged currency doesn’t really have control over their monetary policy in the way we think of it in the US.
Isn’t that basically what the EU is?
Each country has a ‘euro’ that happens to be pegged to other countries’ ‘euro’ at 1:1. Ok, it’s not exactly like pegging, but several of the effects are similar. Debt can be problem, as Greece is experiencing. They can’t inflate their currency and are experiencing de facto deflation.
During the '90s, China had a de facto peg to the dollar, and the currency was considered undervalued. Seemed to work ok for them for a while. They might actually still be a bit undervalued compared to the dollar.
Also in the early 90s, Argentina was pegged to the dollar. It was one of the drivers of an economic crisis. One of the responses was to take away the peg in the late 90s. It devalued Argentina’s replacement currency massively, but the alternative was also bad. Rock and a hard place problem.
Seems like the health of the underlying economy and the amount of fiscal responsibility has a lot to do with the success of currency pegs.
The Cayman Islands pegs its dollar to the US dollar. $1.25 US = $1 Cayman (or at least it did in '98 when we went there). I think they peg it that way so prices look cheap to U.S. tourists.
In any store you can give them U.S. dollars or Cayman Is dollars. You usually get change in Cayman Is dollars, but you can ask for U.S. and most places will give you that if you prefer. (That’s useful on your last day there :-).
They do not have control over their monetary policy really as this works only because everyone knows you can make this exchange. If the U.S. started experiencing rapid inflation, then the Cayman Is. would have to as well or they’d have to delink their currencies. They could try to say we’ll continue to link them but now it takes $1.50 U.S. to buy a C.I. dollar, but once they do that, there will be fear it might happen again and stores might be reluctant to accept U.S. dollars. This might well hinder tourism.
The KYD is still pegged at the same rate as when it became legal tender in 1974, long before tourism became such a major player in the Cayman economy.
The rate is a relic from earlier times. Cayman was administered as a part of Jamaica prior to Jamaican independence. The Jamaican dollar was essentially (early 1970’s) half a UK pound sterling. Cayman issued its own dollars and the KYD was initially pegged 1:1 with the JAM. When Jamaica sought independence, Cayman opted to remain a UK overseas territory. The JAM floated on the open market but Cayman chose to peg its currency to the USD at a rate that reflected the then current exchange rate. That exchange rate was, at the time, essentially linked to the GBP:USD rate.
Not even necessarily at official exchanges. If I issue 100000 leahcim-quid and say it is pegged to the euro at a 1:1 rate, and you come back to me with lq1000 and ask me to exchange for €1000, that’s more euros than I have on hand and I won’t be able to make the exchange even if I want to. My official exchange rate doesn’t mean squat if I can’t follow through, which is why countries with pegged currencies tend to have have large foreign currency reserves (or have limited convertibility, but usually that’s a sign of the peg failing).
That being said, if I develop a reputation for always being able to exchange my leahcim-quid for euros in all circumstances and am completely credible in that ability, then my peg will apply everywhere else as well. After all, if someone, somewhere else in the world is asking for only €0.90 for lq1 in some secondary market, anyone could buy up that all of that guy’s supply, and exchange it with me for €1 per lq, and make free profit. Similarly if someone else is asking €1.10/lq, someone could buy lq from me for €1 and then sell it to him for €1.10 for free profit. Markets abhor free profit so in either case the price adjusts.
In external markets, a country that credibly can exchange currency at the peg rate acts as a large market maker for the currency and the peg is held in all markets through arbitrage. When the country’s peg is less than completely credible, external markets can pay a different price because of that lack of credibility.
It’s in some ways better and worse than a peg. If Greece, instead of going euro, kept the drachma and pegged it to the euro, it could always issue debt in drachmas and then adjust the peg. Greek bond holders wouldn’t like it, but it would be doable. Greece can’t adjust the price of the “greek euros” at all, even through extreme political action.
The euro is more like a gold standard. Greek debts are denominated in a substance that it has very limited control over the production of. It’s a little better than gold in that there is an central bank that at least takes Greek economic conditions into account when setting policy, but it’s not like an independent or even pegged currency that can be adjusted solely for Greek benefit.
The topic is well covered above.
Note that foreign exchange is a confiddence game - in the strict meaning of confidence. If you peg a currency too far off its real worth, people who know will find ways around.Tthey will haord dollars; they will use liquid assets (gold, jewelry, etc.) they will offer discounts for those who pay in Dollars, Euros. or other “reliable” currencies.
If the pegee country then wants to stop this slide, they have to institute progressively more nasty rectrictions - no exchanging for dollars, no importing dollars, no hoarding gold, etc.
This slide in value would be caused because the goverment prints too much currency, and so cannot cover the debt (as leachim points out) when people want to convert to dollars or euros.
Greece is in a somehwat similar situation. it cannot “create” Euros; if the Greek banks start making up Euros (“our govenrment account has an extra trillion Euros”) then other euro banks will be reluctant to allow a negative balance to open up for fear of being caught short. Soon all teh other banks stop trusting it. stop cashing its cheques, honoring its VISA cards, etc. If it tries to buy Euro currency to hand out cash for depositors making withdrawals, it won’t get any. Greek pensioners and civil servants, construction companies doing work for Greece, don’t get apid, etc…
Of course, if the country has a lot of currency, then nobody expects them to default on obligations, everyone accepts the money at par.