Fixed Currency Regimes: Exploiting pegged currencies for profit

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Trading a fixed currency is one of the low risk high reward ways of profiting in the forex market. Although it is not that popular among traders, a seasoned trader with good analytical skills can pocket very large profits with this method in short time provided that he is patient and only takes those opportunities which suit his expectations.

What is a pegged currency?

A pegged currency is a monetary unit the value of which is fixed to that of another. By choosing this path, the central bank of the pegging nation is abandoning monetary independence. Since any difference between the interest rates of the pegged currency and the controlling currency would be exploited by arbitrageurs distorting the exchange rate, the pegging central bank has no choice but to mirror the monetary policies of the other.

Pegged currencies are maintained by central banks at a fixed rate. In many cases, pegs are introduced following political or economic turmoil, and the rate is usually determined by historical factors. However, unless the capital account is closed (which means that the private sector cannot exchange currencies and buy and sell assets internationally), there will be small fluctuations around the aimed fixed rate as declared by the central bank. Traders of pegged currencies profit from these fluctuations by betting, in most cases, that the peg will hold.

Why does a nation maintain a fixed currency regime?

In most cases the purpose is controlling inflation. Since government traditions in emerging markets are weak, political incentives for inflating the money supply strong, and the independence of monetary authorities is limited, or non-existent, inflation can become rampant and uncontrollable by the traditional method of raising the interest rates. As the public expects prices to go up, and press for higher wages in return, firms raise prices, and a feedback loop based on the psychological attitude of market participants can last indefinitely, doing massive harm to the economic health of a nation.

Usually, the government which created the inflationary phase is unwilling to solve the problem, and as it gets replaced at elections, the new government is handed over a situation which demands radical solutions. One of these radical solutions is the currency peg that we’re discussing in this article; by instituting it, the government is making a clear, irreversible, and reliable commitment to keeping any growth of money supply beyond that of the controlling central bank limited by the actual inflow of foreign currency into the nation through external activities. In other words, the printing presses of the pegging nation will be used only as often as that of the controlling nation which is often a developed world country with a credible and well-established policy.

Sometimes central banks and governments introduce pegs in preparation for a monetary union. Since the currency of the pegging nation will be abolished in time, it is beneficial to allow the public to get used to the new unit of value by maintaining a peg, while the new regulations and institutions are being built. The ERM (European Exchange Rate Mechanism) which preceded the launch of the Euro, or the present Danish peg, are examples of this kind of regime.

It is also possible that a peg be maintained for purely political reasons, with only limited economic justifications. In the case of the Gulf Arab States, and their much publicized, and criticized dollar pegs, the main benefit is the political and military support of the U.S. These nations have a sufficiently favorable current account position to build up considerable forex reserves, and as they are not exporters, they do not need to maintain a low exchange rate to help their trade income. Although the dollar peg is useful for controlling inflation sometimes, at other times the monetary policy of the U.S. can be highly inflationary, negating this benefit. But as the Gulf States mainly seek the political benefits of maintaining their pegs, this issue is mostly ignored by them.

Pegs can also be introduced temporarily in response to currency crises, without any relationship to inflation. Usually such regimes are removed in time. HK and Malaysia, for example, both introduced a fixed currency regime in response to the massive speculative attack during the Asian crisis of 1998.