What Is a Linked Exchange Rate System?
A linked exchange rate system is a method of managing a nation's currency that links it to another currency at a specified exchange rate. While linked to one currency, the managed currency can still float against other currencies.
How Does a Linked Exchange Rate System Work?
Countries establish currency exchange rate policies with other countries, such as Hong Kong and the U.S., which entail an agreement to tie, or peg, one currency's value to the other. This keeps the exchange rate at a stable level between the two countries. It also means that, regardless of various economic events taking place, the cost of items will remain the same between the two pegged currencies.
If the exchange rate begins to shift too much from the established, fixed ratio, currency is added to or removed from circulation by a central bank to bring the ratio back into the acceptable range. The currency being managed may be issued only when there are reserves in the linked currency to back it up.
Linked exchange rate systems have been beneficial to some countries. The Hong Kong dollar has been linked to the U.S. dollar for more than 30 years. During this time, Hong Kong has developed into an international financial center, and its assets in its banking system have grown by 13 times. Its gross domestic product also has multiplied nearly 10 times.
- The advantage of a linked exchange rate system is that it stabilizes the currency and keeps inflation low.
- Pegging currencies to each other can make trading and impacts on a country's GDP more predictable.
- Linked currencies experience less fluctuation, which makes it easier to predict their movements but harder for individuals to profit during currency trading.
Example of a Linked Exchange Rate System
Africa's largest economy resides in Nigeria, and its currency was linked to the U.S. dollar for many years. By 2016 though, the country's economy had been sliding into a recession and the country made a decision to unpeg its currency, the naira, from the U.S. dollar. Nigeria's central bank removed the peg in an attempt to remedy chronic foreign currency shortages that stood in the way of Nigeria's growth as an important part of Africa's economy.
The naira became a "managed float" currency, meaning that its currency value fluctuates over time, and its central bank attempts to influence the currency's value relative to that of other countries' currencies through buying and selling various currencies to keep within a certain exchange-rate range.
Limitation of the Linked Exchange Rate System
A country's central bank loses some of its control over interest rates, inflation and other issues of basic monetary policy with a linked currency. For example, if the pegged country is doing well, another country with a linked currency can't use currency depreciation to its advantage in trading with foreign partners and can't implement monetary policy to adapt to shifts in the domestic economy.
Often countries that use a linked exchange rate system specify a trading range around the selected exchange rate. This band around the fixed rate, which is often plus or minus 1%, adds some flexibility to the regime. Some countries have also employed a "crawling peg" system. This system allows for an adjustment of the fixed rate to compensate for differences in certain economic factors between the managed currency country and the country of the linked currency.