Global Finance

Md Raiyan Sadid Sarker

TP058328

Intake: APU3F2302IBM

SUBMISSION: 21 May 21, 2023

1.0 Explain why some countries suddenly peg their currency to the dollar or some other
currency.

Introduction:

Currency pegging refers to the practice of fixing a country's exchange rate to another currency,
such as the U.S. dollar or another stable international currency. While currency pegs are often
established for long periods, some countries may choose to suddenly peg their currency due to a
range of economic factors. This article aims to provide a comprehensive analysis of the reasons
why countries opt for sudden currency pegging and elaborates on the motivations behind such
decisions.

1. Economic Stability and Credibility:

One of the key motivations for sudden currency pegging is to achieve economic stability and
enhance credibility in the international market. By pegging their currency to a stable foreign
currency like the U.S. dollar, countries aim to reduce exchange rate volatility, create a more
predictable environment for trade and investment, and instil confidence among investors and
market participants. (Kuttner, 2023)

2. Inflation Control:

Countries experiencing high inflation rates may choose to peg their currency to control and
stabilize domestic prices. By pegging their currency to a low-inflation foreign currency,
countries can effectively import price stability. This can help manage inflationary pressures,
restore confidence in the domestic currency, and provide a solid foundation for long-term
economic growth. (Mundell, R. 2022)
3. Trade Facilitation:

Currency pegging simplifies international trade transactions by reducing exchange rate risks and
uncertainties. Sudden currency pegging to a major global currency eliminates fluctuations in
exchange rates, making it easier for businesses to plan and forecast costs accurately. This
stability fosters trade facilitation, improves competitiveness, and encourages increased economic
activity and cross-border trade. (Rose, A.K. 1999)

4. Debt Management:

Countries burdened with excessive foreign debt may opt for sudden currency pegging as a
strategy to manage their debt obligations effectively. By pegging their currency, countries can
mitigate the risk of sudden exchange rate fluctuations, reducing the uncertainty surrounding debt
servicing. This stability can make debt repayments more manageable, potentially attracting more
favorable borrowing terms and assisting in debt restructuring efforts. (D. Bordo & Flandreau,
2001)

5. Attracting Foreign Investment:

Sudden currency pegging can be a tool to attract foreign investment. By pegging their currency
to a strong and stable foreign currency, countries create a more favourable investment climate.
This stability enhances investor confidence, reduces risks associated with exchange rate
fluctuations, and encourages foreign direct investment. Pegging to a reliable foreign currency
signals economic stability and can help attract capital inflows. (Mundell, R. 2022)

6. Monetary Stability and Financial Integration:

Some countries may choose to peg their currency to enhance monetary stability and facilitate
financial integration. Aligning with a stable foreign currency or joining a monetary union can
provide a framework for harmonizing monetary policies, promoting cross-border investment, and
deepening economic cooperation. Currency pegging within a larger economic bloc or adopting a
common currency can eliminate exchange rate risks, enhance monetary stability, and foster
regional economic integration. (Calvo & Reinhart, 2000)

7. Crisis Management:

During periods of economic crises, sudden currency pegging can be employed as a short-term
measure to restore stability and confidence. By pegging their currency, countries aim to stabilize
the exchange rate, limit currency depreciation, and restore faith in the domestic currency. This
temporary anchor helps instil stability in financial markets, allowing policymakers time to
implement necessary reforms and address the underlying causes of the crisis. (Calvo & Reinhart,
2000)

Conclusion:

The decision to suddenly peg a country's currency to the U.S. dollar or another currency is
influenced by a combination of economic factors. Motivations for sudden currency pegging
include achieving economic stability, controlling inflation, facilitating trade, managing debt,
attracting foreign investment, promoting monetary stability, facilitating financial integration, and
crisis management. However, the success of currency pegging depends on effective policy
implementation, strong economic fundamentals, and ongoing management. It is important for
countries considering sudden currency pegging to carefully assess their unique circumstances
and potential risks before implementing such a strategy.

2.0 Examine the forces that break the peg when such countries are unable to maintain the peg.

When a country is unable to maintain a currency peg, several forces can contribute to the
breakdown of the peg. These forces can arise due to economic, financial, or policy-related
factors. Let's elaborate on the key forces that can lead to the breakage of a currency peg:

Imbalances in the Macro economy:

Having persistent macroeconomic imbalances, such as excessive inflation, fiscal deficits, or
levels of debt that cannot be sustained, can put a pressure on a nation's capacity to keep its
currency pegged. These imbalances cause a decline in market confidence and a rise in the risk
premium associated with the currency that is pegged. As a direct consequence of this, market
participants may start selling the native currency, which will put downward pressure on the
exchange rate and make it impossible for the authorities to maintain the peg. (Reinhart, C., &
Rogoff, K., 2004)

External Shocks:

A currency peg can also be broken by unexpected and unfavorable shocks from the outside
world. These shocks may take the form of shifts in the prices of global commodities, alterations
in investor sentiment, or financial crises in other nations. These types of shocks are disruptive to
a nation's balance of payments, deplete a nation's foreign exchange reserves, and make it harder
to defend a currency's fixed exchange rate. As the amount of pressure continues to grow, it's
possible that the authorities will be compelled to give up on the peg. (Bor do, M., & Flandreau,
M., 2003)

Speculative Attacks:

Investors launch a speculative attack when they begin betting against a country's currency
because they believe it is overvalued or cannot be maintained. By engaging in practises like
shorting the home currency or selling investments, speculators put downward pressure on the
exchange rate. If speculative pressures mount to an unacceptable level, the central bank may
decide to abandon the peg rather than risk depleting its reserves defending it. Calvo, G., &
Reinhart, C, 2000).

Loss of Confidence:

Investors launch a speculative attack when they begin betting against a country's currency
because they believe it is overvalued or cannot be maintained. By engaging in practices like
shortening the home currency or selling investments, speculators put downward pressure on the
exchange rate. If speculative pressures mount to an unacceptable level, the central bank may
decide to abandon the peg rather than risk depleting its reserves defending it. Obstfeld, M., &
Rogoff, K, 2001)

Insufficient Foreign Reserves:

Enough foreign exchange reserves are required to act in the foreign exchange market and support
the exchange rate that has been set to keep a currency peg in place. When a nation's foreign
reserves are insufficient or are being depleted at a rapid rate, maintaining the peg becomes a
more difficult task. If the central bank does not have sufficient reserves, it may have difficulty
satisfying the demand for the pegged currency, which could ultimately result in the peg
becoming unanchored. (Flood, R. P., & Marion, N. 2002)

Policy Constraints:

The policy constraints imposed by the currency peg itself can become a force that breaks the peg.
Pegged exchange rate regimes often require strict monetary and fiscal policies to maintain the
desired parity. These constraints can limit a country's ability to implement independent monetary
policy, respond to domestic economic conditions, or pursue necessary adjustments during times
of crisis. Over time, these constraints may become untenable, leading to the abandonment of the
peg. (Alesina, A., & Barro, R. 2002)

These forces are not mutually exclusive and can often interact with each other, exacerbating the
pressures on the currency peg. It's important to note that the specific forces that lead to the
breakdown of a currency peg can vary depending on the country and its unique circumstances.

Reference:
Reinhart, C., & Rogoff, K. (2004). The modern history of exchange rate arrangements: A
reinterpretation. Quarterly Journal of Economics, 119(1), 1-48.

Alesina, A., & Barro, R. (2002). Currency unions. The Quarterly Journal of Economics, 117(2),
409-436.

Flood, R. P., & Marion, N. (2002). Holding international reserves in an era of high capital
mobility. IMF Working Paper No. 02/62.

Obstfeld, M., & Rogoff, K. (2001). The six major puzzles in international macroeconomics: Is
there a common cause? NBER Macroeconomics Annual, 15(1), 339-390.

Bordo, M., & Flandreau, M. (2003). Core, periphery, exchange rate regimes, and globalization.
NBER Working Paper No. 9557.

Kuttner, R. (2023, April 28). The Economy Is Still Doing Well. The American Prospect.
https://prospect.org/api/content/b34ba542-e544-11ed-8ede-12163087a831/

Mundell, R. (2022) Inflation and real interest | Journal of Political Economy: Vol 71, no 3.
Available at: https://www.journals.uchicago.edu/doi/10.1086/258771 (Accessed: 21 May 2023).

Rose, A.K. (1999) One money, one market: Estimating the effect of common currencies on
Trade, NBER. Available at: https://www.nber.org/papers/w7432 (Accessed: 21 May 2023).

D. Bordo, M. and Flandreau, M. (2001) Core, periphery, exchange rate regimes, and
globalization. Available at: https://users.nber.org/~confer/2001/globes01/bordo.pdf (Accessed:
21 May 2023).

Calvo, G., & Reinhart, C. (2000). Fear of Floating. https://doi.org/10.3386/w7993

1. International Monetary Fund (IMF):

- "Exchange Rate Regimes: Choices and Consequences" (IMF, 2019)

- "Currency Unions" (IMF, 2018)

2. World Bank:

- "Global Economic Prospects" (World Bank)

3. Central Bank Publications:

- Check the websites of central banks, such as the U.S. Federal Reserve, European Central
Bank (ECB), Bank of England, etc., for publications and reports on exchange rate policies,
currency pegging, and related topics.

4. Academic Papers:

- Mundell, R. "Inflation and Real Interest," Journal of Political Economy

- Rose, A. "One Money, One Market: Estimating the Effect of Common Currencies on Trade,"
Economic Policy

- Bordo, M., and Flandreau, M. "Core, Periphery, Exchange Rate Regimes, and Globalization,"
NBER Working Paper

- Alesina, A., and Barro, R. "Currency Unions," The Quarterly Journal of Economics

- Calvo, G., and Reinhart, C. "Fear of Floating," The Quarterly Journal of Economics