What Is a Crawling Peg?
A crawling peg is a system of exchange rate adjustments in which a currency with a fixed exchange rate is allowed to fluctuate within a band of rates. The par value of the stated currency and the band of rates may also be adjusted frequently, particularly in times of high exchange rate volatility. Crawling pegs are often used to control currency moves when there is a threat of devaluation due to factors such as inflation or economic instability. Coordinated buying or selling of the currency allows the par value to remain within its bracketed range.
Understanding Crawling Pegs
Crawling pegs are used to provide exchange rate stability between trading partners, particularly when there is weakness in a currency. Typically, crawling pegs are established by developing economies whose currencies are linked to either the U.S. dollar or the euro. Crawling pegs are set up with two parameters. The first is the par value of the pegged currency. The par value is then bracketed within a range of exchange rates. Both of these components can be adjusted, referred to as crawling, due to changing market or economic conditions.
Why Pegs Crawl
The primary objective when a crawling peg is established is to provide a degree of stability between trading partners, which may include the controlled devaluation of the pegged currency to avoid economic upheaval. Due to high inflation rates and fragile economic conditions, the currencies of Latin American countries are commonly pegged to the U.S. dollar. As a pegged currency weakens, both the par value and the bracketed range can be adjusted incrementally to smooth the decline and maintain a level of exchange rate predictability between trading partners.
Exchange rate levels are the result of supply and demand for specific currencies, which much be managed for a crawling currency peg to work. To maintain equilibrium, the central bank of the country with the pegged currency either buys or sells its own currency on foreign exchange markets, buying to soak up excess supply and selling when demand rises. The pegged country may also buy or sell the currency to which it is pegged. Under certain circumstances, the pegged country’s central bank may coordinate these actions with other central banks to intervene during times of high volume and volatility.
Disadvantages of Crawling Pegs
Because the process of pegging currencies can result in artificial exchange levels, there is a threat that speculators, currency traders or markets may overwhelm the established mechanisms designed to stabilize currencies. Referred to as a broken peg, the inability of a country to defend its currency can result in a sharp devaluation from artificially high levels and dislocation in the local economy.
An example of a broken peg occurred in 1997 when Thailand ran out of reserves to defend its currency. The decoupling of the Thai baht from the dollar started the Asian Contagion, which resulted in a string of devaluations in Southeast Asia and market selloffs around the globe.