This article looks at the history of FX rates valuation and the pros and cons of pegged systems.
Most countries make use of either the fixed or floating FX rates method of determining their currency value. These were not always available and a very different method of currency valuation was used in the past.
History of Exchange Rates
The late 1800s and the early 1900s saw fixed global exchange rates. At the time, global currencies were linked to the value of gold reserves the country had in holding. This allowed countries to fix their exchange rate at a figure that could be exchange in gold. This method was named the gold standard. This system allowed for unrestricted movement of capital, trade stability and global currency. This method of rate determination was abandoned at the start of the First World War.
After the Second World War, an effort was made to stabilise global economies after the ravages of the war. There was a requirement to increase global trade at the time. This meant that a review of the governing of international money exchange had to be done. It was at this time that the International Monetary Fund was established to maintain stable exchanges between countries and to promote international trade. The view at the time was that this action would cause a stabilisation of the global economy.
Global countries agreed to a fixing of currencies. However, at this stage, it was not to gold again, but to the US dollar. At that point the US dollar was fixed at $35 per ounce of gold. If a country felt the need to adjust its currency value, the IMF had to be involved to enable the move. This method of valuation continued through to 1971 when the US was unable to maintain the fixed rate of gold. Larger economies made the decision to base their currency value on a floating system. Attempts to revert to a global fix were finally abandoned during 1985. The gold system was abandoned completely and none of the major economies have reverted to a fixed system since then.
Pegged FX Rates
The main reason why countries choose to fix their FX rates is for stability. Developing countries make use of this method to attract investment and to provide a stable market for the investment. For investors a pegged system is less risky as they know exactly what they are buying into. The value of their investment remains fixed as there are no daily fluctuations in the forex rate. A country with a stable currency will attract investors as they feel more confident about investment. This pushes the demand for the currency up which lowers the inflation rate.
It is quite difficult for countries to maintain pegged rates. It could at times lead to financial crises. This is what occurred during the 1990s in Mexico, Asia and Russia. These countries attempted to maintain currencies with high values which ultimately led to an overvaluation of their currencies. The respective governments finally reached a point where they were unable to meet the demand for their domestic currency’s conversion to the foreign currency, at the very high fixed rate. The panic this caused made investors withdraw their funds as they wanted to attempt conversion before the currencies were devalued. This action depleted the foreign reserves in those countries. The Mexican government was forced to devalue its currency by a whopping 30%.
Countries with pegged forex rates are normally said to run an unstable, unsophisticated capital market. They also have failing regulatory bodies within the country.
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