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 which can be readjusted to account for changing market conditions or macroeconomic trends. An example of managed currency or "dirty float",these periodic adjustments are usually intended to improve the country's competitive position in the export market and world financial stage.
- An adjustable peg describes a currency regime where a country allows its currency's value to float on the market, but only within a narrow band before the central bank intervenes to restore the peg.
- Typically, the currency is allowed to fluctuate within a narrow band before the peg is restored; however, the peg itself can be reviewed and adjusted according to economic conditions and macro trends.
- The adjustable peg is a hybrid system seeks to take advantage of the benefits from both a fixed peg and freely floating currency.
Understanding Adjustable Peg
An adjustable peg can float on the market according to economic conditions, but typically has only a 2 percent degree of flexibility against a specified base level or peg. If the exchange rate moves by more than the agreed-upon level, the central bank intervenes to keep the target exchange rate at the peg. Over time, the peg itself can be re-evaluated and changed to reflect changing conditions and trends. The ability of countries to revalue their peg to reassert their competitiveness is at the crux of the adjustable peg system.
The adjustable peg 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 an Adjustable Peg
An example of what has been considered a mutually beneficial adjustable currency peg is the Chinese yuan's link to the U.S. dollar. Once a hard peg, the Chinese yuan (CNY) is allowed to fluctuate in a narrow band between 0.3% and 0.5% before intervention.
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 its exchange rate is often 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.
China briefly decoupled from the dollar in 2005 and again in December 2015, switching to a basket of 13 currencies, but discreetly switched back in both cases.