Currency pegs

Whiteboard currency pegs

Unless you live in a sheep croft in the Scottish highlands, you probably know that China unpegged its currency from the US dollar over the weekend. Big news, which the Marketplace Morning report covered in as much depth as it can in two minutes, and to which newspapers committed considerable amounts of real estate. The way the politicians have been squawking about it, you'd have to assume it's a big deal, but at the morning meeting today, we wondered how many people really understand currency pegs?

Here's a list of questions we tried to answer.

1. Why does one country peg its currency to another's?

2. How does the peg work?

3. What happens when the peg goes away? To imports? To exports?

4. What difference does it make to individual consumers when their own currency floats free?

Judging by the looks on the faces around the table, currency is one of those hazy areas. People get the gist of it, but they tend to get lost in the details. Which begs the question, is it worth filling them in on those details?

We think the answer is yes, it is worth it, so we gave it a valiant stab today. Kai Ryssdal and Scott Tong answered the third question in an interview. And Jeremy Hobson talked about how currency fluctuations affect individual consumers (not much, as it turns out).

As for how a peg works, and why countries opt to have them, well, I thought I'd have a go at that.

There are a number of reasons why one country might peg its currency to another's, but the main one these days is to make trade with that country easier. Say I'm a chocolatier, living in L.A. and to make my chocolate, I buy a ton of cocoa a month from Brazil. Let's assume that there are no disruptions or gluts in the harvest over a year, and that ton of cocoa costs 2000 Brazilian reals each month. Because the real isn't pegged to the dollar, I still have no idea how much my cocoa will cost in dollars each month. If the dollar's strong, my cocoa will be cheaper. If it's weak, it'll be more expensive.

Why should the cocoa farmer give a monkey's about that? Well, because if the dollar is weak, I may not be able to afford to buy as much cocoa from him. Trading cocoa in dollars wouldn't help him either: he'd be paid in dollars, which he'd have to convert to his own currency. If the dollar was weak against the real, he'd end up with less money to go shopping with.

So you can see how having the real fixed to the dollar would help me and my cocoa farmer friend. China decided to peg to the dollar because it's such a big trading partner of ours. And many oil producers peg to the dollar because oil is traded in greenbacks on the open market.

So how does the peg work?

Well, it's a bit like a yacht race, where one of the yachts decides to shadow another yacht. She can go a little bit ahead, or a little bit behind, but the plan is to sail pretty much neck and neck.

But of course the yachts are built differently, so the same weather can affect them in different ways, and sometimes the yacht has to speed up to keep up with its target and sometimes she has to slow down.

So how does the helmsman vary her speed? By tightening or loosening the sheet rope. Tighten up, and the sails go stiff and the yacht moves faster. Slack off, and the yacht slows down.

The central banker is the helmsman. If he thinks his currency isn't keeping pace, he tightens up, by buying up his own currency. By hauling it in, he decreases the amount that's available in the open market. And we all know that if supply decreases relative to demand, the price goes up, bringing him level with his peg.

If he finds his currency is overheating, or getting too expensive relative to his target currency, he loosens up, letting his currency spill into the market by selling it off. That increases supply, reduces demand, and pushes the price down.

So what does he use to buy his own currency up with? You've heard of foreign reserves? That's when countries stock up on dollars or euros or pounds or even gold. They use those reserves to buy up their own currency when they need to.

The peg creates stability in the market between the two countries. Plain sailing, if you like. But there's a big downside. What if the target country runs into trouble? If you've tied your fortunes to a country that runs into spiraling inflation or deflation it could land you in the drink ... not to mention badly needing one.

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