What Is an Adjustable Peg?
An adjustable peg is an exchange rate policy in which a currency is pegged or fixed to a major currency such as the U.S. dollar or euro but can be readjusted to account for changing market conditions. The periodic adjustments are usually intended to improve the country's competitive position in the export market.
Understanding Adjustable Peg
An adjustable peg typically has 2 percent flexibility against a specified level. If the exchange rate moves by more than the agreed-upon level, the central bank intervenes to keep the target exchange rate peg. The ability of countries to revalue their peg to reassert their competitiveness is at the crux of the adjustable peg system.
The system stems from the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, in 1944. Under the Bretton Woods Agreement, currencies were pegged to the price of gold, and the U.S. dollar was seen as a reserve currency linked to the price of gold.
Following Bretton Woods, most Western European nations pegged their currencies to the U.S. dollar until 1971. The agreement dissolved between 1968 and 1973 after an overvaluation of the U.S. dollar led to concerns about the exchange rates and tie to the price of gold. President Richard Nixon called for a temporary suspension of the dollar’s convertibility. Countries were then free to choose any exchange agreement, except for the price of gold.
Example of a Currency Peg
An example of what has been a mutually beneficial currency peg is the Chinese yuan's link to the U.S. dollar. China briefly decoupled from the dollar in December 2015, switching to a basket of 13 currencies, but discreetly switched back in January 2016.
As an exporter, China benefits from a relatively weak currency, which makes its exports relatively less expensive compared to exports from competing countries. China pegs the yuan to the dollar because the U.S. is China's largest import partner. The stable exchange rate in China and a weak yuan also benefit specific businesses in the U.S. For example, stability allows businesses to engage in long-term planning such as developing prototypes and investing in the manufacturing and importing of goods with the understanding that costs will not be affected by currency fluctuations.
One disadvantage of a pegged currency is that it is kept artificially low, creating an anti-competitive trading environment compared to a floating exchange rate. Many domestic manufacturers in the U.S. would argue that is the case with the yuan's peg. Manufacturers consider those low-priced goods, partially the result of an artificial exchange rate, come at the expense of jobs in the U.S.