Why do small countries that trade a lot generally prefer to fix their exchange rates?

What Is a Fixed Exchange Rate?

A fixed exchange rate is a regime applied by a government or central bank that ties the country's official currency exchange rate to another country's currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band.

Key Takeaways

• The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band.
• Fixed exchange rates provide greater certainty for exporters and importers and help the government maintain low inflation.
• Many industrialized nations began using the floating exchange rate system in the early 1970s.

Fixed Exchange Rate

Understanding a Fixed Exchange Rate

Fixed rates provide greater certainty for exporters and importers. Fixed rates also help the government maintain low inflation, which, in the long run, keep interest rates down and stimulates trade and investment. 

Most major industrialized nations have had floating exchange rate systems, where the going price on the foreign exchange market (forex) sets its currency price. This practice began for these nations in the early 1970s while developing economies continue with fixed-rate systems.

Bretton Woods

From the end of World War II to the early 1970s, the Bretton Woods Agreement meant that the exchange rates of participating nations were pegged to the value of the U.S. dollar, which was fixed to the price of gold.

When the United States' postwar balance of payments surplus turned to a deficit in the 1950s and 1960s, the periodic exchange rate adjustments permitted under the agreement ultimately proved insufficient. In 1973, President Richard Nixon removed the United States from the gold standard, ushering in the era of floating rates.

The Beginnings of the Monetary Union

The European exchange rate mechanism (ERM) was established in 1979 as a precursor to monetary union and the introduction of the euro. Member nations, including Germany, France, the Netherlands, Belgium, and Italy, agreed to maintain their currency rates within plus or minus 2.25% of a central point.

The United Kingdom joined in October 1990 at an excessively strong conversion rate and was forced to withdraw two years later. The original members of the euro converted from their home currencies at their then-current ERM central rate as of Jan. 1, 1999. The euro itself trades freely against other major currencies while the currencies of countries hoping to join trade in a managed float known as ERM II.

Disadvantages of Fixed Exchange Rates

Developing economies often use a fixed-rate system to limit speculation and provide a stable system. A stable system allows importers, exporters, and investors to plan without worrying about currency moves.

However, a fixed-rate system limits a central bank's ability to adjust interest rates as needed for economic growth. A fixed-rate system also prevents market adjustments when a currency becomes over or undervalued. Effective management of a fixed-rate system also requires a large pool of reserves to support the currency when it is under pressure.

An unrealistic official exchange rate can also lead to the development of a parallel, unofficial, or dual, exchange rate. A large gap between official and unofficial rates can divert hard currency away from the central bank, which can lead to forex shortages and periodic large devaluations. These can be more disruptive to an economy than the periodic adjustment of a floating exchange rate regime.

Real-World Example of a Fixed Exchange Rate

Problems of a Fixed Exchange Rate Regime

In 2018, according to BBC News, Iran set a fixed exchange rate of 42,000 rials to the dollar, after losing 8% against the dollar in a single day. The government decided to remove the discrepancy between the rate traders used—60,000 rials—and the official rate, which, at the time, was 37,000.

In June 2010, China's government decided to end a 23-month peg of its currency to the U.S. dollar. The announcement, which followed months of commentary and criticism from United States politicians, was lauded by global economic leaders.

China's economic boom over the last decade has reshaped its own country and the world. This pace of growth required a change in the monetary policy in order to handle certain aspects of the economy effectively—in particular, export trade and consumer price inflation. But none of the country's growth rates could have been established without a fixed, or pegged, U.S. dollar exchange rate.

Chinese currency pegging is the most obvious recent example, but they are not the only one that has used this strategy. Economies big and small favor this type of exchange rate for several reasons, despite some potential drawbacks.

The Pros And Cons Of A Pegged Exchange Rate

Pros of a Fixed/Pegged Rate

Countries prefer a fixed exchange rate regime for the purposes of export and trade. By controlling its domestic currency a country can—and will more often than not—keep its exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad. For example, let's assume a euro (EUR)/Vietnamese dong (VND) exchange rate. Given that the euro is much stronger than the Vietnamese currency, a T-shirt can cost a company five times more to manufacture in a European Union country, compared to Vietnam.

But the real advantage is seen in trade relationships between countries with low costs of production (like Thailand and Vietnam) and economies with stronger comparative currencies (the United States and the European Union). When Chinese and Vietnamese manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit that is made through the exchange rate. So, keeping the exchange rate low ensures a domestic product's competitiveness abroad and profitability at home. (For more insight, check out "Currency Exchange: Floating Versus Fixed.")

Currency Protection

The fixed exchange rate dynamic not only adds to a company's earnings outlook, it also supports a rising standard of living and overall economic growth. But that's not all. Governments that have sided with the idea of a fixed, or pegged, exchange rate are looking to protect their domestic economies. Foreign exchange swings have been known to adversely affect an economy and its growth outlook. And, by shielding the domestic currency from volatile swings, governments can reduce the likelihood of a currency crisis.

After a short couple of years with a semi-floated currency, China decided during the global financial crisis of 2008 to revert back to a fixed exchange rate regime. The decision helped the Chinese economy to emerge two years later relatively unscathed. Meanwhile, other global industrialized economies that didn't have such a policy turned lower before rebounding.

Key Takeaways

• By pegging its currency, a country can gain comparative trading advantages while protecting its own economic interests.
• A pegged rate, or fixed exchange rate, can keep a country's exchange rate low, helping with exports.
• Conversely, pegged rates can sometimes lead to higher long-term inflation.
• Maintaining a pegged exchange rate usually requires a large amount of capital reserves.

Cons of a Fixed/Pegged Rate

There are downsides to fixed currencies, as there is a price that governments pay when implementing the pegged-currency policy in their countries. A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves, as the country's government or central bank is constantly buying or selling the domestic currency.

China is a perfect example. Before repealing the fixed-rate scheme in 2010, Chinese foreign exchange reserves grew significantly each year in order to maintain the U.S. dollar peg rate. The pace of growth in reserves was so rapid it took China only a couple of years to overshadow Japan's foreign exchange reserves. As of January 2011, it was announced that Beijing owned $2.8 trillion in reserves—more than double that of Japan at the time.

The problem with huge currency reserves is that the massive amount of funds or capital that is being created can create unwanted economic side effects—namely higher inflation. The more currency reserves there are, the bigger the monetary supply, which causes prices to rise. Rising prices can cause havoc for countries that are looking to keep things stable.

Example Concerning the Thai Baht

These types of economic elements have caused many fixed exchange rate regimes to fail. Although these economies are able to defend themselves against adverse global situations, they tend to be exposed domestically. Many times, indecision about adjusting the peg for an economy's currency can be coupled with the inability to defend the underlying fixed rate. The Thai baht was one such currency.

The baht was at one time pegged to the U.S. dollar. Once considered a prized currency investment, the Thai baht came under attack following adverse capital market events during 1996-1997. The currency depreciated and the baht plunged rapidly, because the government was unwilling and unable to defend the baht peg using limited reserves.

In July 1997, the Thai government was forced into floating the currency before accepting an International Monetary Fund bailout. Even so, between July of 1997 and October 1997, the baht fell by as much as 40%.

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