ANALYSIS OF PEGGING SYSTEM IN FOREIGN EXCHANGE

MARKETS

(A PROJECT SUBMITTED TOWARDS PARTIAL FULFILLMENT OF ASSESSMENT RULES IN THE

SUBJECT OF FINANCIAL MANAGEMENT AND REGULATORY SYSTEMS)

Submitted by: Submitted to:

Atyotma Gupta Ms. Varendyam Tiwari
Roll no. 1162 Faculty of Law
VII Semester
B.B.A. L.L.B. (Corporate Law Hons.)

NATIONAL LAW UNIVERSITY, JODHPUR

SUMMER SESSION
(JULY-AUGUST 2017)
 TABLE OF CONTENTS

INTRODUCTION ............................................................................................................................... 3

UNDERSTANDING OF THE BASICS ................................................................................................. 43

Floating Exchange Rates ........................................................................................................ 54

Pegged exchange rate.............................................................................................................. 76

Soft pegs ................................................................................................................................... 87

Crawling Pegs .......................................................................................................................... 87

Adjustable Pegs ....................................................................................................................... 87

Pegged currency system v. fixed regime ............................................................................... 98

EXCHANGE RATE REGIME FOR INDIAN ECONOMY .................................................................... 98

The Exchange Rate Policy and Modelling in India............................................................ 109

TO PEG OR NOT TO PEG:- CONCLUDING COMMENTS ............................................................. 1110

Pros and cons of Pegging .................................................................................................... 1110

REFERENCES............................................................................................................................. 1413

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 INTRODUCTION
A competitive and freely determined exchange rate always benefits the competitive growth of the
Commented [n1]: First thing to be discussed is the
entire world. But not every country let the exchange rate to be freely adjust as per the demand and difference between de facto and de jure classification of
exchange rate regimes.
supply and this is the point where actual intervention from governments and central bank becomes
Commented [n2]: A currency union is an agreement
pertinent. For any country the exchange rate is considered as a relative price in order to arrive at among members of that union (countries or other
jurisdictions) to share a common currency, and a
its macroeconomic configuration. There are innumerous differences between the exchange rate single monetary and foreign exchange policy.
Formatted: Highlight
regimes followed by countries across the world and therefore there cannot be a strict and rigid
Formatted: List Paragraph, Numbered + Level: 1 +
classification of different regimes. The de-facto regimes practiced by countries differs technically. Numbering Style: 1, 2, 3, … + Start at: 1 + Alignment:
Left + Aligned at: 0.25" + Indent at: 0.5"
The de jure classification is comparatively simpler to make. De jure exchange rate regime is what
Commented [n3]: It is a monetary authority which is
is proclaimed to be followed by the governments and is also classified by the International required to maintain fixed exchange rates with other foreign
currencies. Therefore there is complete intervention and
Monetary Fund (only with respect to its member countries).1 restriction on the regime of a country by its monetary
authority.

The IMF identified the drawbacks associated with de jure classification of foreign exchange
regimes and classified all the regimes into 8 categories which includes de facto and de jure
classification of foreign exchange regimes2:-
1. 1. Currency unions (another currency as the legal tender) for example Nepal and Bhutan
peg their currencies to the Rupee, and accept it as legal tender(also hong kong dollar used
by Macau and Hong Kong).; 2. Currency Boards; 3. Conventional Currency Pegs (pegging
against a single currency or a basket of currency) for example a dollar peg. ; 4. Pegged
exchange rates within horizontal bands; 5. Crawling pegs; 6. Crawling bands; 7. Managed
floating with no predetermined exchange rate; 8. Independent floating
There are three things here. Pegged exchange rate with horizontal bands in which the currency
of a country is maintained within the band width which is decided by the government on the
basis of different factors. In this case the band width is fixed and the exchange rate to be
maintained by the government is also fixed.
1
Annual Report on Exchange Arrangements and Exchange Restrictions, published annually by the IMF accessed from
https://www.imf.org.
2 the central value as against which the peg is fixed is allowed
Benito Juarez, Dollar Peg or Euro Peg? An Application of the Synthesis technique on the Indian rupee, accessed
from http://www.igidr.ac.in/conf/money/mfc-12/An%20application%20of%20the%20synthesis%20tec hnique%
20on%20indian%20rupee_suvojit%20chakravarty.pdf.
Currency Boards are monetary regimes based on an explicit
legislative commitment to exchanging the domestic currency
for a specified foreign currency at a fixed exchange rate. The
domestic currency is issued only against foreign exchange
and that remains fully backed by foreign assets, eliminating
traditional
central bank functions, such as monetary control and lenders
of last resort, and leaving little scope for discretionary
monetary policy. Some flexibility may still be afforded,
depending on how strict the rules of the boards are. In the
case of Hong Kong, although it operates a currency board
system, the monetary authority can still be, and is regarded
to have a role of, lenders of last resort, because it is backed
by the People’s Republic with enormous assets and foreign
reserves.
In U.S.A as well, the Federal Bank serves as the lender of
last resort and does not intervene usually and hence this
situation is not a currency board. The federal reserves is the
true central bank in the United States.
Formatted: Highlight
Commented [n4]: The rate is allowed to fluctuate in a
fixed band (bigger than 1%) around a central rate. One
version of the "pegged with horizontal bands" is E. Ray
Canterbery's delayed peg. Fluctuations occur within a 2
percent band, sufficiently wide to allow some trade
adjustments and considerable short-term capital flows, but
narrow enough to avoid unusually large fluctuations.
Commented [n5]: A crawling peg is a regime where the
exchange rate is fixed by the authority within a fixed band of
rates and that rate is periodically allowed to fluctuate within
that fixed band.
Commented [n6]: A crawling band is when the band or
to fluctuate.
Field Code Changed

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 Crawling pegs is the system where the exchange rate is crawling in fixed portions or The
currency is adjusted periodically in small amounts at a fixed rate or in response to changes in
selective quantitative indicators. The band has nothing to do here.

Now crawling bands is the regime. The currency is maintained within certain fluctuation
margins of at least ±1 percent around a central rate-or the margin between the maximum and
minimum value of the exchange rate exceeds 2 percent-and the central rate or margins are
adjusted periodically at a fixed rate or in response to changes in selective quantitative
indicators.

Bands are either symmetric around a crawling central parity or widen gradually with
an asymmetric choice of the crawl of upper and lower bands (in the latter case, there
may be no preannounced central rate). The commitment to maintain the exchange
rate within the band imposes constraints on monetary policy, with the degree of
policy independence being a function of the band width.

This paper seeks to explain and differentiate between these 8 categories of regime identified by
the IMF. It also seeks to envisage the legal and regulatory framework which provides for the de
jure regime followed by the Indian economy. It entails to provide for a basic and conceptual
understanding of these regimes through graphical and diagrammatical representations.

UNDERSTANDING OF THE BASICS

Generally, a country’s government maintains a fixed exchange rate by either buying or selling its
own currency on the open market. This is one reason governments maintain reserves of foreign
currencies. If the exchange rate drifts too far below the desired rate, the government buys its own
currency in the market using its reserves. This places greater demand on the market and pushes
up the price of the currency. If the exchange rate drifts too far above the desired rate, the
government does the opposite. Exchange rate policies come in a range of different forms. This can
be easily explained with the help of the following figure:-

Floating Soft Exchange Hard Exchange Merging Currencies

Exchange rates Rate Pegs Rate Pegs

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 The exchange rate Exchange Rate is Central Bank The currency is
of a country is usually determined intervenes strongly to made identical to
completely by market but keep the currency the currency to
determined by Central Bank prices fixed at a another country.
market forces. intervene sometime certain level. (for example:-
currency unions. )

Floating Exchange Rates

In this types of regime, the government or the agency specified by the government does not play
any role in determining the exchange rate for the country’s domestic currency. The exchange rate
fluctuates as per the market forces of demand and supply. For exampleexample, the US Dollar is
a floating currency. The relationship between the governments and foreign exchange markets, in
such kinds of free-floating systems can be compared to that of the relationship between the
government and stock markets in India. On one hand, the government or any other agency
authorized by the government can interfere in the functioning of the free floating markets in the
same way as they can interfere in the functioning of stock exchange markets in India i.e. to prevent
any kind of fraud, misappropriation, insider trading etc. it cannot interfere in the functioning and
determination of the exchange rates of such foreign exchange markets.3

For example:-example: - If suppose there is a change in the tastes and preferences of people and
the goods and services produced in the Indian Market rise sharply, then the same would lead to
rise in the prices of goods and services and a consequent rise in the demand of Indian currency.
This is pure and crude economics which can be explained by virtue of the following graphs.

3
Exchange Rate Systems, accessed from http://open.lib.umn.edu.

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 1 USD 1 USD
= 64.72 = 63.96
INR INR

In the above graph, the appreciation of Indian rupee with respect to USD has been shown. It clearly
shows that when the demand for India Rupee increases from D to D1 the exchange rate also
increases from 64.72 to 63.96 INR for 1 USD. The notable factor here is the constant supply of
Indian currency, which is not practicable. When the exchange rate is increasing the supply of
Indian currency (exchange of Indian currency for USD in cases of foreign exchange markets) will
also increase to a certain extent, which will in turn result in depreciation of Indian rupee. However
this process will take sometime during which the relative value of Indian rupee in terms of USD
will remain at the appreciated exchange rate. The price of India rupee has again depreciated and
this time it is even more than what was maintained by the government. It is 65.30 as opposed to
64.72.

There is a lot of criticism for free-floating exchange rate system. It has often beingbeen argued
that a fixed or even for that matter a pegged currency exchange rate system entails a regime
whereas the exchange rates are more predictable and stable. In a floating rate regimeregime, the
determination of exchange rates are left best to the fluctuations of demand and supply.

This has been rebutted by the economist Milton Friedman in his book Capitalism and Freedom
whereas he compared the floating exchange rates with a free price system for goods and services.
He argued that pursuing a floating exchange rate system does not imply that the prices or the
exchange rates are left to fluctuate without any restrictions, but it is restricted by the stability of
the forces of demand and supply of a foreign currency.4 Commented [n7]: His argument is that in a floating
exchange rate system the demand and supply of a currency
does not rise that sharply and frequently such that it will lead
to unpredictable and unusual fluctuations in the market.
Formatted: Highlight
4
Milton Friedman, Capitalism and freedom, University of Chicago Press, 1962.

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Pegged exchange rate

A pegged exchange rate is the rate where the government or the Central Bank of a country
intervenes in the functioning of the exchange rate and influences its determination. This is affected
due to the forces of demand and supply in the economy with the only difference that these forces
are now modified by the government in order to undervalue or overvalue the foreign value of a
currency.5 The following graph may be referred to for a better understating of the concept.

INR/$ INR/$

The above figure shows the process of pegging the value of Indian Rupee in terms of USD. In the
first graph the value of Indian currency (as per the market forces of demand and supply) is lower
than what is actually intended by the government. ThereforeTherefore, the government releases
Indian currency in foreign exchange market which increases the supply of Indian currency thereby
reducing the price (exchange rate) of Indian currency (appreciation of INR vis-à-vis USD as now
there are more sellers/suppliers of INR with constant demand). This is the process of
overvaluation/revaluation of Indian currency.

The second graph indicates the process of devaluation/deliberately effected depreciation of INR
vis-à-vis USD. When the government buys its own currency from the foreign exchange market to

5
There's one move that almost always sets off chaos in the currency market, August 22, 2016, accessed from
http://www.businessinsider.in.

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reduce the supply of Indian rupee and hence resulting in a consequent increase in the exchange
rate and reduction in demand of the Indian currency.

Soft pegs

A soft peg is the name for an exchange rate policy where the government usually allows the
exchange rate to be set by the market, but in some cases, especially if the exchange rate seems to
be moving rapidly in one direction, the Central Bank will intervene in the market. Commented [n8]: Seldom intervention by the
government.

Crawling Pegs Formatted: Highlight

A crawling peg is a hybrid of fixed and flexible exchange rate systems. As the exchange rate of a
country is made to crawl in fixed terms by the interference of the government. However these
crawl rates of a currency is determined by the government on the basis of market considerations.
Under this regime, while the external value of the currency is determined in terms of another
currency (reference), this peg keeps on changing by itself as per the underlying economic dynamics
of demand and supply, and hence it allows the market forces play a role in the determination of
the change in exchange rate.

There are several parameters which could be analyzed in order to ascertain the direction of change
in the exchange rate for instance – the actual exchange rate which is prevailing in the foreign
exchange market, there are gradual modifications with permissible variations around the restricted
parity. Commented [n9]: This restricted parity is the bands which
are fixed and the rate is allowed to fluctuate within that
bands. It should be more than 1% and less than the central
The change in this parity per unit period is subject to a specified cap with an additional short value fixed.
Bracketed Bands.
term constraint, for example, it can be specified that parity change in a month cannot be more than
1/10th of the yearly limit. Parity changes are specified on the basis of a set of selective quantitative
indicators which may be discretionary, automatic or presumptive. For example:-example: -
current account deficits, changes in reserves, relative inflation rates etc. Countries such as Portugal
and Brazil have adopted variants of Crawling Peg.

Adjustable Pegs

Adjustable Peg system has been established as a regime where the exchange rates were fixed
initially by the governments or the central banks, with the provision of changing them if the
necessity rose. Under the new system, all the members of IMF were mandatorily required to fix

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the par value of their currency either in terms of gold, or USD. The par value of the US dollar was
fixed at $ 35 per ounce.

All of the above values were fixed with the prior approval of IMF. The member countries agreed
to maintain the exchange rates for their respective currencies within a band of 1% on either sides
of the fixed par value. The extreme points were referred to as upper and lower support point.

The respective authorities in each member state were to be prepared to buy or sell the US dollar
and thereby support the exchange rates. For this purpose, a country which would freely buy and
sell gold at the aforementioned par value for the settlement of international transactions was
required to be maintaining its exchange rate within the 1% band.

Pegged currency system v. fixed regime

Pegged exchange rate system is hybrid of fixed and floating exchange rate regimes. A country will
"peg" its currency to a currency or to a basket of currencies. This choice is affected by the
currencies in which the external debt of that country is denominated and the extent to which the
trade of the country is concentrated with those other countries. For example: - considering these
factors during pre-independence the Indian currency was pegged to the currency of Britain. The
case for pegging to a single currency is made stronger if the peg is made to the currency of a
principal trading partner.

Pegged exchange rates are generally used by smaller and newer nations. In order to defend against
a specific exchange rate, they may need the central bank’s intervention, imposition of tariffs,
quotas, or for placing restrictions on capital in/outflow. If the pegged exchange rate is too less or
more than the actual market rate, it will be costly to defend and it will probably not last for a longer
period. It may result in a benefit to the specula tors..speculators.

EXCHANGE RATE REGIME FOR INDIAN ECONOMY

It is noteworthy that the practice of pegging has been followed by Indian economy pre
independence. The Indian currency was pegged to silver before independence.6 But as there were
fluctuations in the currency rates as per the prices of the silver, the Indian rupee was allowed to be

6
The Intriguing History of the Indian Rupee and its Evolution, www.thebetterindia.com.

9|Page
fluctuated as per the market forces of demand and supply after independence. At the time of
independence, the value of Indian rupee was I INR for I USD as compared to 63 at present.

The Exchange Rate Policy and Modelling in India

The exchange rate policy in India has evolved with the opening up of the economy as part of the
macroeconomic reforms and liberalization during early 1990s. In the post-independence period,
India’s exchange rate policy has shifted from a par value system to a basket-peg and further to a
managed float exchange rate system. In order to overcome the weaknesses associated with a
single currency peg (where the Indian rupee was associated with pound sterling) and to ensure
stability of the exchange rate, the rupee was pegged to a basket of currencies from September 1975
till the early 1990s.7

The figure above shows the recourse taken up by the Reserve Bank of India in order to sterilize
the external value of Indian rupee after the process of liberalization and opening up of the economy
was undertaken.8 It shows the time-series of RBI purchases of foreign currency during the

7
Exchange Rate Policy and Modelling in India, April 2016, accessed from https://www.rbi.org.in/scripts
/PublicationsView.aspx?id=12252.
8
Barry Bosworth, Suman Bery, India Policy Forum 2004, Volume 1, Brookings Institution, Washington D.C.

10 | P a g e
specified period. Because the exchange rate was fixed, the data on currency intervention serve as
a proxy for the capital inflow into the economy, for which monthly data are not available.

The similarity between the fluctuations of RBI purchases of foreign currency and the mispricing
on the currency forward market is noticeable. It is consistent with the fact that such mispricing
reflect the then prevalent currency views of private market participants, which would have shaped
their decisions on short-term capital flows. Commented [n10]: Forward mispricing in the graph is
usually done by the arbitrageurs to find out whether there are
any arbitrage opportunities in the market. It is forecasting the
When a central bank or government of a country engages in currency trading, the trading affects changes in the pegged currency but for short term only
unlike speculation.
the reserves of a country. If the capital account is highly open, the scale of currency trading
Formatted: Highlight
required to distort the price on the currency market is larger. In the above case, the purchases of
foreign assets by the central bank led to an increase in the net foreign assets from 20 percent of
reserve money to 45 percent of reserve money.9

Presently as per the proclamation of the Reserve Bank of India, the exchange rate of the Indian
rupee is “market determined” and the exchange rates are not at all administratively determined.10

TO PEG OR NOT TO PEG:- CONCLUDING COMMENTS

If Indian rupee or any currency for that matter does not appreciate or depreciate as per the market
forces of demand and supply, the stock markets of that country will either be too cheap or be either
be too expensive for an investor from any other country to invest in that market. Commented [n11]: Because of the fact that the exchange
rate will be determined by the government and it will not be
same as that of the prevailing exchange rate in the market.
Pros and cons of Pegging

Currency pegs have become popular in the present say world especially after the Bretton Woods
Conference and the establishment of the new monetary regime.11 It was developed at the United
Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, in July
1944. Under this agreement, various currencies were pegged to the price of gold, and the U.S.
dollar was a reserve currency linked to the price of gold.

9
Ila Patnaik, India’s Experience with a Pegged Exchange Rate, 2004, accessed from http://openlib.org /home/ila
/PDFDOCS/Patnaik2004_IndiaExperiencePeggedExchangeRate.pdf.
10
Id.
11
http://www.managementstudyguide.com.

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In 1944, the leading non-communist nations consented for a fixed exchange rate system (which is
popularly known as the Bretton Woods System) and as a result the U.S. dollar was pegged at $35
per ounce and other nations then fixed the value of their currencies in relation to the U.S. dollar.

Pegging of currency assist the government of a country to control or manage its trade and exports,
to curb inflation or to manage deflation or to manage the interest rates. There are many other
benefits of practicing pegging regime for domestic currency. For example: - if there is a new
country formed and companies and investors across the world are reluctant to invest in that country
due to lack of trust as it is a new country and does not have any track record. The government of
that country or the central bank engages into fixed pegging of the currency whereby they fix the
exchange rate of their currency in terms of another currency (which is stable and is established).
This move will allow the currency and the government of the new country to gain more credibility
as the exchange rate will then be more stable. Commented [n12]: Example of in what situations pegging
will be beneficial.
Another advantage of pegging is that it enables the government or the central bank of a country to Formatted: Highlight

maintain a stable and non-fluctuating rate for the currency which may increase the foreign
investment in a particular country. A corollary disadvantage to the same reason is that in such
cases as the external value of a country is at the discretion of the government and therefore it is
riskier for the enterprises to speculate or do business in such countries. Commented [n13]: As the stock prices of that country
will either be too low or too high as compared to what is
prevailing in the international market.
The fact that the decision of governments do affect the past and futuristic decisions of investors
was witnessed by the Switzerland government in 2011 when they decided to abandon its peg
against Euro.12 The proclamation that was made by Thomas Jordan, the Chairman of Swiss
National Bank was that while abandoning the practice of pegging our currency with that of the
Euro, while deciding our policy in future the SNB will be active in the foreign exchange market, if
necessary.13

Therefore this is an indication of practicing a managed floating exchange rate regime where the
government would allow the exchange rates to be determined by the market forces of demand and

12
The pitfalls of pegging the Swiss Franc to Euro, August 11, 2011, The Reuters (London) accessed from:
http://www.reuters.com/video/2012/07/16/the-pitfalls-of-pegging-the-swiss-franc?videoId=218256204
13
How Does a Currency Peg Work? The Currency Fair Blog, accessed from www.currencyfair.com/blog/pegged-
currency-affect-exchange-rates/.

12 | P a g e
supply but it will intervene as and when necessary (especially in those cases where the exchange
rates are appreciating or depreciating rapidly and are extremely unstable).

There is a vast literature on the merits of different exchange rate regimes. I believe that the salient
characteristics of flexible exchange rate regimes have been witnessed to be superior to those of
fixed rate regimes, especially in the longer run. Economic history reinforces these conclusions.
Countries that had abandoned the gold standard typically recovered at a faster rate from tragedies
and economic nightmares like Great Depression.14 In the floating rate regimes, the price signals
are less distorted which results in better investments and allocation decisions. For
exampleexample, in a regime like that of the People’s Republic of China, which has huge inflows
of capital and no currency float, the inflow has apparently driven the cost of capital for ‘well
connected’ to zero. This kind of regimes may result in an improper and inappropriate allocation of
capital and it also does not providesprovide any market discipline for the industry to become more
competitive.

Whether it would be beneficial for a country to peg its currency depends completely upon the
situation of the country. For example, it is not practically possible for Nepal to remove its peg from
the Indian Rupee as the Rashtra Bank of Nepal is not equipped fully at present to run its ow
monetary policy as it does not have the sufficient foreign reserves and it won’t be feasible for the
development of the country to leave the determination of Nealese currency to the forces of demand
and supply.

The different between pegging and fixed exchange rate system is that when a smaller nation pegs
it currency to that of the another currency, the government of that country loses the control of their
currency and that the currency of the smaller nation will fluctuate as per the currency to which it
is pegged.

If a country’s currency value has large fluctuations, foreign companies have a more
difficult time operating and generating a profit. If a U.S. company operates in Brazil, for
example, the firm has to convert U.S. dollars into Brazilian reals to fund the business. If
the value of Brazil’s currency changes dramatically compared to the dollar, the U.S.

14
Barry Eichengreen and Jeffrey Sachs, Exchange Rates and Economic Recovery in the 1930s, Cambridge university
press, The Journal of Economic History, Vol. 45, No. 4 (Dec., 1985), accessed from, http://www.earth.columbia.edu.

13 | P a g e
company may incur a loss when it converts back into U.S. dollars. This form of currency
risk makes it difficult for a company to manage its finances. To minimize currency risk,
many countries peg an exchange rate to that of the United States, which has a large and
stable economy.

REFERENCES
1. Annual Report on Exchange Arrangements and Exchange Restrictions, published annually
by the IMF accessed from https://www.imf.org .

14 | P a g e
 2. Benito Juarez, Dollar Peg or Euro Peg? An Application of the Synthesis technique on the
Indian rupee, accessed from http://www.igidr.ac.in/conf/money/mfc-12/An%20
application%20of%20the%20synthesis%20technique%20on%20indian%20rupee_suvojit
%20chakravarty.pdf.
3. Exchange Rate Systems, accessed from http://open.lib.umn.edu .
4. Milton Friedman, Capitalism and freedom, University of Chicago Press, 1962.
5. There's one move that almost always sets off chaos in the currency market, August 22,
2016, accessed from http://www.businessinsider.in .
6. The Intriguing History of the Indian Rupee and its Evolution, www.thebetterindia.com.
7. Exchange Rate Policy and Modelling in India, April 2016, accessed from
https://www.rbi.org.in/scripts/PublicationsView.aspx?id=12252 .
8. Barry Bosworth, Suman Bery, India Policy Forum 2004, Volume 1, Brookings Institution,
Washington D.C.
9. Ila Patnaik, India’s Experience with a Pegged Exchange Rate, 2004, accessed from
http://openlib.org/home/ila/PDFDOCS/Patnaik2004_IndiaExperiencePeggedExchangeRa
te.pdf.
10. http://www.managementstudyguide.com .
11. The pitfalls of pegging the Swiss Franc to Euro, August 11, 2011, The Reuters (London)
accessed from: http://www.reuters.com/video/2012/07/16/the-pitfalls-of-pegging-the-
swiss-franc?videoId=218256204
12. How Does a Currency Peg Work? The Currency Fair Blog, accessed from
www.currencyfair.com/blog/pegged-currency-affect-exchange-rates/ .
13. Barry Eichengreen and Jeffrey Sachs, Exchange Rates and Economic Recovery in the
1930s, Cambridge university press, The Journal of Economic History, Vol. 45, No. 4 (Dec.,
1985), accessed from, http://www.earth.columbia.edu .

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