Understanding PEG Adjustment: A Guide for Investors
Every country in the world has its exchange rate policy. This policy entails how the national currency is related to the major currencies. These are most commonly the US dollar or Euro. PEG adjustment refers to the currencies whose exchange rate is floating, i.e. adjustable. The country allows the currency value to float according to the market.
However, this happens only in a narrow band. At one moment, the central bank must intervene to restore the peg. Before we tackle peg adjustment in more detail, let’s first see how the exchange rate functions in the foreign exchange market.
Exchange Rate in Forex – How Does it Work?
The two main regimes in exchange rates are floating / adjustable and fixed.
A fixed exchange rate allows you to always exchange one currency for a set amount of another currency. This is common in countries like Saudi Arabia. The currency is tied to the US dollar because oil contracts are priced in dollars.
The exchange rate, also called the parity of a currency, is its price about another. We speak of currency to designate the currency of a foreign country. This term is, therefore, common in foreign exchange matters.
Saying that the euro/dollar exchange rate (EUR/USD) is 1.11 means that selling 1 euro makes it possible to obtain 1.11 dollars. As the proportionality table shows, in the opposite direction, the dollar/euro exchange rate (USD/EUR) is then 0.90. Thus, with the sale of 1 dollar, we can obtain 0.90 euros.
The exchange rate refers to all the purchases and sales of currencies that the market participants make daily. The main participants are commercial banks, central banks, large companies, institutional investors such as insurance companies, etc.).
Adjustable Peg Explained
Regarding adjustable pegs, the currency rate is fixed relative to a standard – often a currency or a basket of currencies – by the central bank that issues this currency.
The rate thus fixed is called the central rate (or fixed parity). And it constitutes the reference exchange rate around which a certain fluctuation margin exists.
The monetary authorities must defend the central rate to keep it within the authorized fluctuation margin. However, authorities can authorize changes to the central rate (devaluation or revaluation) under certain conditions.
There are several forms of fixed exchange rate regimes. Authorities can fix a central exchange rate with a more or less wide authorized fluctuation margin.
In a single currency regime (the case of the Euro), a central bank establishes fixed and irrevocable exchange rates, replacing local currencies with a common currency.
In a currency board system (case of the Argentine peso from 1991 to 2001), the currency issue depends strictly on the quantities of reference currency set aside by the country’s central bank concerned. Sometimes both currencies, local and reference, circulate freely within the country.
Example of a Peg Adjustment
Therefore, the central banks of these countries undertake to provide foreign currency against the national currency at the official rate. Therefore, administrators entirely control the price. However, under a fixed exchange rate regime, governments can devalue or revalue their currency—that is, lower or increase its price relative to other currencies—if they deem the official rate unsuitable.
Finally, the majority of countries have chosen an intermediate exchange rate regime. China is an example of this. A basket of currencies composed of the dollar, the Euro, the yen, and the Korean won indexes the Chinese yuan (or renminbi).
The yuan exchange rate fluctuates on the foreign exchange market but in a limited way, around the basket’s value. The Chinese authorities manage the exchange rate and buy and sell their currency on the market (see “Foreign exchange interventions”).
Special Considerations Peg Adjustment
Many countries are still reluctant to float their currencies for fear of excessive fluctuations and being less successful in controlling inflation expectations. This is particularly true for countries whose bank balance sheets are exposed to exchange rate risk. In these countries, the transmission of inflation through the exchange rate is greater.)
They are also concerned about how they will exit the fixed exchange rate regime. They know that preparing well, acting at the right time, and relying on a sound macroeconomic framework is essential for an orderly exit. In fact, in most cases, crises have pushed countries to abandon fixed exchange rates in favour of floating currencies.
