A Crawling Peg Exchange Rate - What is Crawling Peg?
Counties facing Forex volatility and economic instability may use a crawling peg exchange rate to shield their economy from negative fallout, but what is a crawling peg? We will explain the two types of a crawling peg exchange rate and discuss its advantages and disadvantages.
The Definition of a Crawling Peg Exchange Rate
A crawling peg exchange rate belongs to a fixed exchange rate mechanism but allows the fixed domestic currency to fluctuate between controlled upper and lower bands. Countries with Forex volatility and economic instability may use this combination of a fixed and floating rate model to minimize the effects of economic dislocation, manage inflation expectations, and prevent uncontrolled currency devaluation. Central banks may use a known formula to trigger modifications or resort to frequent adjustments to discourage speculators.
Understanding Crawling Pegs
Countries use a crawling peg to achieve Forex rate stability with trading partners, manage inflation expectations, and prevent uncontrolled currency devaluation. Developing and emerging economies will peg their domestic currency to a foreign one, usually the US Dollar or the Euro.
After a central bank establishes a par value for the currency peg, it computes an upper and lower band, allowing its currency to fluctuate in a controlled environment. The central bank may adjust the par value and currency bands to reflect changing economic or market conditions.
Different Types of Crawling Pegs
Two types of crawling pegs exist, active and passive, dependent on what central banks using a crawling peg want to achieve.
With an active crawling peg, the central bank will announce its upper and lower bands and maintains the peg via buying and selling in the Forex market in small steps, attempting to manipulate inflation expectations.
With a passive crawling peg, each adjustment remains coincidental, usually tied to inflation rate changes, announced monthly or bi-monthly in some countries. The primary goal is to preserve foreign currency reserves.
The Advantages and Disadvantages of Crawling Pegs
Crawling pegs are rare, and presently only two countries use them, and another one deploys a modification resulting in a delayed peg. It is crucial to weigh the advantages and disadvantages of crawling pegs, as outlined below.
Advantages of a crawling peg exchange rate:
- Creates stability between trading partners
- Minimizes Forex fluctuations
- Aids inflation expectations management
- Preserves a decline in foreign exchange reserves
- Prevents uncontrolled devaluation due to high inflation and economic instability
- Allows controlled devaluation to prevent economic issues
Disadvantages of a crawling peg exchange rate:
- Creates artificial exchange rates
- Increases the risk of speculators, Forex traders, and market forces which may crush the mechanism to prevent destabilization of currencies
- Active crawling pegs can drain foreign exchange reserves amid central bank interventions and manipulations
- A broken peg can harm economies, like in 1997, when Thailand used all its currency reserves to defend the Thai Bhat, resulting in an unpegging to the US Dollar, leading up to the Asian Financial Crisis of 1997 amid contagion that forced currency devaluations across Southeast Asia and a global financial market sell-off
Which Economies Use a Crawling Peg System?
Only Nicaragua and Vietnam use a crawling peg system today. China adopted a variation using a floating peg, which some label a delayed peg as proposed by economist E. Ray Canterbery.
Botswana, Argentina, Ecuador, Uruguay, and Cost Rica used a crawling peg or adjustable peg system but abandoned it. While a crawling peg system is rare, the International Monetary Fund notes 53 countries using a conventional peg, 44 countries with a managed float, and 40 with an independent float. Together with ten currency board agreements and ten additional countries defined as de jure dollarization, 157 countries interfere with their domestic currency system.
It shows the global imbalances and necessary work to develop the global economy. Most currency pegs are against the US Dollar or the Euro.
Crawling Peg (Adjustable Peg) Conclusion
A crawling peg exchange rate creates stability between trading partners, especially if one faces high inflation and economic instability. It uses an upper and lower band and helps countries manage their currencies, primarily developing and emerging countries with unstable currencies. An adjustable peg system of exchange rate may include controlled devaluation.
A crawling peg remains vulnerable to speculation as it presents an artificial exchange rate and is dependent on central bank currency manipulation and management. While it may provide a temporary solution to a problem, countries should not rely on it as a permanent solution but use the time to fix structural issues that have required the introduction of a crawling peg.
Why do nations use a crawling peg exchange rate system?
Countries use it to control inflation, protect against uncontrolled currency devaluation due to economic instability, and create stability with their trading partners.
How does a crawling peg fundamentally differ from a pegged exchange rate?
A pegged currency remains fixed, while a crawling peg allows the currency to fluctuate between an upper and lower band. Additionally, a crawling peg enables a country to guide its exchange rate to the desired level at a measured and calculated pace.
What happens when the exchange rate is pegged?
A pegged exchange rate maintains a fixed domestic value to a floating foreign currency. A country will select an acceptable exchange rate, and the central bank ensures it remains fixed. Most currency pegs are against the US Dollar or the Euro.