What is a Currency Band?
A currency band is a currency regulation imposed by a government or central bank that specifies both a price floor and a price ceiling. Between these two specified prices, the currency can float, but at those limits the currency price will stop floating.
- A currency band is a range of acceptable trading prices.
- The band has an upper and lower limit.
- Between the limits, the price can float and the exchange rate is dictated by supply and demand forces.
- A more recent example of a working currency band can be found in the Chinese Yuan.
How a Currency Band works
A currency band can be understood as a hybrid of a fixed exchange rate and a floating exchange rate. A country fixes a range of values at which its currency can float or move within, and the limits where it will revert to a fixed exchange rate. This allows for some revaluation, but usually stabilizes the currency's price back within the band.
For instance, the central bank can bring the currency back to the mid-point rate of the established band. However, if this move is too difficult or challenging to do, the bank will realign the band to create a new target exchange rate. The Chinese yuan is an example of a currency that moves within a currency band.
China has a strictly controlled currency policy which involves regulating the daily movements of the yuan on the forex market. Since it introduced a currency band in 2005, the country has steadily allowed the band to widen against the U.S. dollar over the years, starting at +/-0.3% and finally reaching +/-2% which was introduced in March 2014 and remains the same as of 2017.
The 2% band, for example, means that the yuan is allowed a 2% change up or down against the U.S. dollar (its reference rate) each day. The daily limit suppresses the value of the currency and makes Chinese exports cheaper abroad.
A currency band helps to impose discipline on monetary policy, but still provides flexibility if the country is hit by big capital inflows or outflows. The monetary policy of a country with a currency band is dependent on the behavior of its reference foreign currency because the central bank must make decisions that cause the value of the local currency to change in a way that approximates changes in the value of the reference currency.
The band is used by a government to stabilize its currency during times of exchange rate volatility. Currency bands discourage speculation from forex traders looking to profit from changes in exchange rates. However, investors can use the band as a reference point for expectations of future movements in the exchange rate.