In June , China's government decided to end a month peg of its currency with the U. The announcement was praised by global economic leaders and followed months of commentary and criticism from United States politicians.
But what prompted the long awaited move? The Chinese Model China's economic boom over the last decade has reshaped its own country and the world. Once a country historically known for communist rule and isolationist policies, China has changed gears and become a global economic powerhouse.
This pace of growth required a change in the country's currency policy in order to handle certain aspects of the economy effectively - in particular, export trade and consumer price inflation. But none of the country's prior growth rates could be established without a fixed or pegged U.
And China's not the only one that has used this strategy. Economies big and small favor this type of exchange rate for several reasons. Let's take a look at some of these advantages. By controlling its domestic currency a country can — and will more often than not — keep its exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad. Given that the euro is much stronger than the Vietnamese currency, a T-shirt can cost a company five times more to produce an manufacture in a European Union country as compared to Vietnam.
But the real advantage is seen in trade relationships between countries with low costs of production like Thailand and Vietnam and economies with stronger comparative currencies the United States and European Union. When Chinese and Vietnamese manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit that is made through the exchange rate.
So, keeping the exchange rate low ensures a domestic product's competitiveness abroad and profitability at home. The Currency Protection Racket The fixed exchange rate dynamic not only adds to a company's earnings outlook, it also supports a rising standard of living and overall economic growth.
But that's not all. Governments that have also sided with the idea of a fixed, or pegged, exchange rate are looking to protect their domestic economies. Foreign exchange swings have been known to adversely affect an economy and its growth outlook. And, by shielding the domestic currency from volatile swings, governments can reduce the likelihood of a currency crisis. After a short couple of years with a semi-floated currency, China decided during the global financial crisis of to revert back to a fixed exchange rate regime.
The decision helped the Chinese economy to emerge two years later relatively unscathed. Meanwhile, other global industrialized economies turned lower before rebounding. For more insight, check out Currency Exchange: This type of currency regime isn't all positive. There is a price that governments pay when implementing a fixed or pegged exchange rate in their countries.
A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves as the country's government or central bank is constantly buying or selling the domestic currency.
China is a perfect example. Before repealing the fixed rate scheme in , Chinese foreign exchange reserves grew significantly each year in order to maintain the U. The pace of growth in reserves was so rapid it took China only a couple of years to overshadow Japan's foreign exchange reserves. To learn more, check out How do central banks acquire currency reserves and how much are they required to hold? Importing Inflation The problem with huge currency reserves is that the massive amount of funds or capital that is being created can create unwanted economic side effects — namely higher inflation.
The more currency reserves there are, the wider the monetary supply — causing prices to rise. Rising prices can cause havoc for countries that are looking to keep things stable. Learn more about inflation in our Inflation Tutorial. The Thai Experience These types of economic elements have caused many fixed exchange rate regimes to fail. Although these economies are able to defend themselves against adverse global situations, they tend to be exposed domestically.
Many times, indecision about adjusting the peg for an economy's currency can be coupled with the inability to defend the underlying fixed rate. The baht was at one time pegged to the U.
Once considered a prized currency investment, the Thai baht came under attack following adverse capital market events during The currency depreciated and the baht plunged rapidly because the government was unwilling and unable to defend the baht peg using limited reserves. In July , the Thai government was forced into floating the currency before accepting an International Monetary Fund bailout.
Bottom Line Given both pros and cons of a fixed exchange rate regime, one can see why both major and minor economies favor such a policy choice. By pegging its currency, a country can gain comparative trading advantages while protecting its own economic interests. However, these advantages also come at a price. Ultimately, however, the currency peg is a policy measure that can be used by any nation and will always remain a viable option.
Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Currency Trading The Chinese Model China's economic boom over the last decade has reshaped its own country and the world.
The Thai baht was one such currency. How much a fixed asset is worth at the end of its lease, or at the end of its useful life. If you lease a car for three years, A target hash is a number that a hashed block header must be less than or equal to in order for a new block to be awarded.
Payout ratio is the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage. The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...