Fixed Exchange Rates, Their Pros and Cons With Examples
What the Riyal, Lev, and Krone All Have in Common
A fixed exchange rate is when a country ties the value of its currency to some other widely-used commodity or currency. Today, most fixed exchange rates are pegged to the U.S. dollar. That's because the dollar is used for most transactions in international trade. Countries also fix their currencies to that of their most frequent trading partners.
In the past, currencies were fixed to the value of gold.
In the 1944 Bretton Woods Agreement, countries agreed to peg all currencies to the dollar. The United States agreed to redeem all dollars for gold. President Nixon took the dollar off of the gold standard in 1971 to end the recession. Nevertheless, many countries kept their currencies pegged to the dollar. That's because the dollar is the world's reserve currency. He ended the 200-year history of the gold standard.
A fixed exchange rate tells you that you can always exchange your money for the same amount of the other currency. It allows you to determine how much of one currency you can trade for another. For example, if you go to Saudi Arabia, you know the dollar will buy you 3.75 Saudi riyals. That's because the dollar's exchange rate in riyals is fixed. Saudi Arabia did that because its primary export, oil, is priced in U.S. dollars. All oil contracts and most commodities contracts around the world are written and executed in dollars.
A fixed exchange rate provides currency stability. Investors always know what the currency is worth. That makes the country's businesses attractive to foreign direct investors. They don't have to protect themselves from wild swings in the currency's value. They are hedging their currency risk.
A country can avoid inflation if it fixes its currency to a popular one like the U.S. dollar or euro. It benefits from the strength of that country's economy. As the United States or EU grows, its currency does as well. Without that fixed exchange rate, the smaller country's currency will slide. As a result, the imports from the large economy become more expensive. That imports inflation.
For example, the dollar's value is 3.75 in Saudi riyals. Let's say a barrel of oil is worth $100, or 375 riyals. If the dollar strengthens 20 percent against the euro, the value of the riyal, which is fixed to the dollar, has also risen 20 percent against the euro. To purchase French pastries, the Saudis pay less than they did before the dollar strengthened. That's why the Saudis didn't need to limit supply as oil prices fell to $50 a barrel in 2014. The value of money is what it purchases for you. If most of your country's imports are to a single country, then a fixed exchange rate in that currency will stabilize prices.
One country that is loosening its fixed exchange rate is China. It ties the value of its currency, the yuan, to a basket of currencies including the dollar. In August, it allowed the fixed rate to vary according to the prior day's closing rate.
It keeps the yuan in a tight 2 percent trading range around that value.
China has to manually adjust the exchange rate of the yuan to the dollar. The U.S. government pressured the Chinese government to let the yuan rise in value. It wanted U.S. exports to be competitively priced in China. It also makes Chinese exports to the U.S. more expensive. It's an attempt to lower the U.S. trade deficit with China.
A fixed exchange rate can be expensive to maintain. A country must have enough foreign exchange reserves to manage its currency's value.
The country's currency can become a target for speculators. They can "short" the currency, artificially driving its value down. The central bank must convert its foreign exchange to prop up its currency's value. If it doesn't have enough, it will have to raise interest rates.
That will cause a recession.
That happened to the British pound in 1992. George Soros kept shorting the pound until the UK central bank gave in and allowed the pound to float. In 2014, it happened when Switzerland had to release the Swiss franc from its fix to the euro, which had plummeted in value.
There are several ways countries maintain a fixed exchange rate. The purest form is when its currency is pegged to a set value to a single currency. Many countries fix a set value to a basket of currencies. Others maintain their currency within a range. They peg it to either a single currency or to a basket of currencies. Here are examples of each type.
Currency Fixed at a Set Value to a Single Currency
These countries promise to always give the same amount in their currency for each unit of currency to which it is fixed.
|Country||Currency||Peg (on 1/15/18)||Fixed To:|
|Bahamas||Bahamian dollar||1.00||U.S. dollar|
|Brunei||Brunei dollar||1.00||Singapore dollar|
|Hong Kong||Hong Kong dollar||7.75||U.S. dollar|
|Saudi Arabia||Riyal||3.75||U.S. dollar|
Currency Loosely Fixed
|China||Yuan||2% trading band around yesterday's midpoint||Basket weighted toward U.S. dollar|
|Singapore||Singapore dollar||Managed within trading band to allow a slow rise||Basket|
|Vietnam||Dong||2% trading band (devalued 12/30/16)||U.S. dollar|