The news is by your side.

- Advertisement -

Currency Pegs

0 1

Get real time updates directly on you device, subscribe now.

A currency peg is when someone in charge declares that one currency is
worth a fixed amount of another currency and then attempts to maintain
that exchange rate by matching the supply of either currency with the
demand. If people think that you have got your peg wrong, a black market
can emerge where people trade the currencies at what they perceive to be
a more accurate exchange rate.
How do you maintain a peg? Firstly, you threaten. You announce the
pegged rate, and then declare penalties for people found deviating from
it. This may mean fines, prison, or perhaps something worse. But you
also need to be credible and try to prevent black markets from emerging.
Credibility comes from having enough of both currencies to match
whatever a trader might want to exchange.
For example, let’s say you are the king of a country and you declare a peg
of one apple = one orange. If one year for whatever reason people really
want apples, the demand for apples will exceed the demand for oranges.
So people might be prepared to pay two oranges for one apple. But you’ve
declared a peg, so everyone will come to you with the oranges that they
declared a peg, so everyone will come to you with the oranges that they
don’t want and demand one apple for each orange they bring you. So to
keep the peg, you better have a lot of apples to give out. If you don’t have
them, then a black market will emerge that excludes you, and people will
start trading one apple for more than one orange, making a mockery of
your peg. So you need to have at least as many apples in reserve as there
are oranges in circulation.
And vice versa. If, on the other hand, people really want oranges, you’re
going to need a lot of oranges to hand out, and you’ll be receiving apples
(which no one wants) in return.
So to maintain a peg to the very end, you need as many apples in reserve
as there are oranges in circulation, and you need as many oranges in
reserve as there are apples in circulation. Or in the fiat world, you need to
back your fiat currency 100% with the currency you are pegging to, at the
peg rate—an arrangement known as a ‘currency board’.
While central banks can prevent their currencies from going up in value
by creating as much fiat currency as they want and therefore capping the
value of their currency, it is harder for them to prevent their currencies
from going down in value, because they need other currencies with which
to buy their own currency back in order to prop its price up.
This is essentially how George Soros broke the Bank of England: He had
more ammo than the Bank.
George Soros and the Bank of England
Rohin Dhar details the story on priceonomics.com49: in October 1990, the
Bank of England joined the European Exchange Rate Mechanism (ERM)
and committed to keep the exchange rate of Deutsche marks and pounds
sterling to between 2.78 and 3.13 marks per pound. By 1992, it had
become obvious to the market that sterling was valued too highly, even at
the floor of 2.78 marks per pound, and the real price of sterling should
have been lower.
In the months leading up to September 1992, Soros, via his Quantum
hedge fund, borrowed pounds from anyone he could, and sold them to
anyone who would buy them. Borrowing something to sell it with an
intention to buy it back later as a lower price is known as ‘going short’.
According to an article in The Atlantic50, Soros built up a short position of
$1.5bn worth of pounds. On the night of Tuesday, 15 September, the fund
accelerated its bet and sold more, extending the fund’s short position
from $1.5bn worth to $10bn worth, and pushing the price of sterling
lower and lower overnight while the Bank of England was absent from
the markets.
The following morning, the Bank of England had to buy sterling in order
to prop up the value of the pound and maintain the peg they committed
to. But what can the Bank of England buy pounds with? Their reserves—
other currencies or borrowed money. The Bank of England announced
that they would borrow up to $15bn in order to buy pounds. And Soros
was prepared to sell that amount to neutralise the demand created by the
Bank of England… it was a game of brinkmanship. So, the Bank bought
£1bn of sterling over several batches, and raised short term interest rates
by two percentage points to make Soros’ loans expensive (remember,
Soros was borrowing sterling in order to sell it, and had to pay interest on
the pounds he was borrowing). But it was too late. The markets didn’t
react, and the price of sterling didn’t rise. At 7.30pm that evening the
Bank of England was forced to exit from the ERM and let sterling float.
Over the next month the price of sterling fell from 2.78 marks to 2.40
marks per pound. That critical Wednesday was known as Black
Wednesday, and Soros became known as the man who broke the Bank of
Bretton Woods
The Bretton Woods meeting was all about currency pegs. On 1 July 1944,
during World War II, delegates from forty-four countries met in Bretton
Woods, New Hampshire, USA, for twenty-one days of discussion to
normalise commercial and financial relations.
The outcome was a kind of international gold standard agreement where
the US dollar was pegged to gold at $35 per troy ounce and other
currencies were pegged to the dollar (with 1% wiggle room) and could be
redeemed for gold at the US Treasury. The International Monetary Fund
was established, as was the International Bank for Reconstruction and
Development (IBRD, which would eventually become part of the World
Bank). At that time, ordinary Americans were still banned from owning
non-jewellery gold.
Prior to this, in 1931 Britain, most of the Commonwealth, except Canada,
and many other countries had abandoned the gold standard. Bretton
Woods therefore marked a return to some kind of gold standard.
The Bretton Woods Agreement didn’t work very well. Countries
frequently devalued their currencies with respect to the dollar and gold.
For example, in 1949, Britain devalued the pound by about 30% from
$4.30 to $2.80, and many other countries followed suit.
In 1971 the Bretton Woods agreement broke down after the US stopped
honouring the convertibility of dollars to gold. This coincided with a big
drop in US gold reserves and increase in foreign claims on US dollars.

Get real time updates directly on you device, subscribe now.

Leave A Reply

Your email address will not be published.

Subscribe to our newsletter
Sign up here to get the latest news delivered directly to your inbox.
You can unsubscribe at any time

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More