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Pegging The Best Foreign Exchange Rates

Pegging The Best Foreign Exchange Rates

There are two methods used to determine the value of one currency to another.  The fixed or floating systems are the ones most commonly used.  This was not always the case and in the past a very different method was used to obtain the best foreign exchange rates for a country.

History of the Best Foreign Exchange Rates

During the late 1800s and early 1900s, global exchange rates were fixed.  In those days, all currencies were linked to the amount of gold reserves the country held.  This allowed the currency exchange rate to be fixed at a rate that could be exchanged in gold ounces.  This was called the gold standard.  It allowed for global currency and trade stability and unrestricted capital movement.  This method was abandoned when the First World War commenced.

The end of World War Two saw an effort to stabilise the global economy.  There was also a need to increase trade on a global level.  This called for a review of the governance of international monetary exchange.  The International Monetary Fund was created to promote trade internationally and to maintain the stability of monetary exchange between countries.  The view was that this would in turn, stabilise the global economy.

Countries agreed that currencies would revert to being fixed, not to gold, but to the US dollar.  The US dollar was fixed at $35 per ounce.  If there was a requirement for a country to have its currency value readjusted, it had to consult with the IMF to enable the adjustment.  This method continued until 1971 when the US dollar was no longer able to maintain its pegged rate per gold ounce.  This prompted the larger economies to adopt a floating system.  Attempts to go back to a global fix were stopped in 1985.  None of the major economies have used a pegged system since then, and the gold standard was abandoned.

Pegging

The main reason for pegging a currency is stability.  Developing countries generally peg the currency to attract foreign investment and provide a stable environment for this investment.  With a pegged currency, the investor is sure about the value of his investment as there will not be daily fluctuations to affect the investment.  The stability of a country’s currency generates confidence in it.  This allows for a lowering of inflation and an increase in demand for the currency.

A peg is quite difficult to maintain for long periods of time and this could lead to a financial crisis.  This was the case during the 1990s in Russia, Asia and Mexico.  Their attempts to maintain high value currencies resulted in their respective currencies being overvalued.  The governments reached a point where they were no longer able to meet the demand for local currency conversion into foreign currency at that high pegged rate.  The ensuing panic caused investors to withdraw their money with the idea to convert it prior to the devaluation of the currencies.  This caused a depletion of the foreign reserves in the respective countries.  The Mexican government had no option but to devalue its currency by 30%.

Countries that operate under the pegged system are generally associated with running unsophisticated and unstable capital market.  It is also stated that these countries have weak regulatory bodies.

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