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Why is a Pegged Exchange Rate Controversial?

By Louis Holding-Parsons on August 7, 2019

5 (100%) 1 vote[s]

A pegged exchange rate is not usually interesting enough to make it on Twitter! Unless you are Donald Trump that is. Another Trump rant on Twitter should not come as a surprise. What he ranted about was surprising though. Not since Bill Clinton has a country openly been called a currency manipulator.

Pegged exchange rate terminology…

Pegged currency rate is Forex newsA pegged exchange rate is when a currency is fixed against the value of another currency. This stops the exchange rate from “floating”, I.e. Going up or down based on economics and Forex news. Although there is usually a particular rate a country will defend (China has traditionally not allowed its currency to fall below 7 yuan to the US dollar), there is some “give” to this rate. Otherwise institutional traders would be able to create easy and highly profitable strategies. Easy Forex trading almost never happens with Forex trading.

How a pegged exchange rate can be weaponised

CNY USD a good example of a pegged exchange rateA good example of a pegged exchange rate is the Chinese Yuan. The USA has been a particularly vocal critic of the Devaluation of currency. Indeed the Chinese leadership has regularly seaked to maintain a Peg slightly below the 7 Yuan to 1 Dollar (see above). Although this peg has recently been broken it should be seen in the context of the wider developing trade war between China and the USA. This militarisation of the Yuan, i.e. Being used as a weapon in the negotiation between the USA and China is a new development. Beijing is using it as a means to fight back on the trade tariffs imposed by Donald Trump.

Method behind the madness

It is generally not a good idea to pick a fight with the USA, but the PBOC has its reasons. It is acting in what it perceives as the best interest of China and its people. The PBOC’s lack of independence may be difficult to fathom for the West but makes perfect sense for the Chinese communist party. Keeping prosperity is key. If that means drawing the ire of the US by devaluing it’s currency to increase its competitive then so be it! A key part of China’s wealth is exporting goods it manufactures. By making its currency cheaper, it makes the prices of these goods cheaper and therefore more competitive.

Eyes on the prize

A pegged currency rate has its rewardsAlthough the US has complained about the devaluation of the Yuan, it has benefited indirectly. Major US companies manufacture many of their products in China and benefit from the cheaper Yuan. The US government in turn benefits from higher taxes receipts when these same companies report increased profits! Equally Beijing allowed the Yuan to be less competitive during the financial crisis so as to indirectly help US companies buying from China. The cynical would suggest this was also to help the slowing growth but make no mistake, Beijing is business savvy. This manipulation of the Yuan based on economic conditions may be linked to politics, but also shows how sensitive they are to economic growth. 

Stability can be a driver…

HKD USD is another example of a pegged exchange rate

Although a pegged exchange rate is often for financial reasons, there can be other issues at stake. An example is the USD HKD which as traded within a band since 2005. It has never broken the HK$7.75 to HK$7.85 per U.S. dollar. Hong Kong is seen as a mini Geneva, namely somewhere to park your money in relative safety. Trading in a band means little volatility, which is attractive to Beijing as well as investors. Hong Kong is a financial powerhouse which increases Beijing prestige as well as access to international investors. As with any pegged exchange rate, whenever it is tested, intervention takes place to protect the peg. In this case, it is the Hong Kong Monetary Authority, which has regularly done so to ensure stability.

Reversal of trend

Pegged currency rate is a trend to be wary ofKnowing the long-term trend is attractive to a retail Forex trader but be wary of the unexpected! Anyone looking to trade the Yuan-Dollar can seemingly do so with confidence that the 7 yuan to the US dollar level won’t be broken. Yet if the PBOC changes policy and does let the Yuan devalue, as it has over the past few days, then you could loose big time. Just ask anyone who was on the wrong side of the EURCHF trade back in 2015!

Conclusion

A pegged currency rate is usually for underlying political reasons. A leadership looking for re-election or to stay in power for extended periods of time needs to keep their citizens happy. Beijing’s strategy is for economic prosperity by making its manufacturers goods price competitive. This is achieved by keeping the price of the Yuan versus the Dollar artificially low. In effect this is state aid. For those learning to trade Forex, a currency with what appears to be a clear direction is a boon for profits. Be wary though, nothing is ever permanent in trading and learning to be open-minded and flexible will stand you in good stead!

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis Holding-Parsons

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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