Fixed Currency Regimes: Exploiting pegged currencies for profit

[armondtoth]

Trading a fixed currency is one of the low risk high reward ways of profiting in the forex market. Although it is not that popular among traders, a seasoned trader with good analytical skills can pocket very large profits with this method in short time provided that he is patient and only takes those opportunities which suit his expectations.
What is a pegged currency?

A pegged currency is a monetary unit the value of which is fixed to that of another. By choosing this path, the central bank of the pegging nation is abandoning monetary independence. Since any difference between the interest rates of the pegged currency and the controlling currency would be exploited by arbitrageurs distorting the exchange rate, the pegging central bank has no choice but to mirror the monetary policies of the other.

Pegged currencies are maintained by central banks at a fixed rate. In many cases, pegs are introduced following political or economic turmoil, and the rate is usually determined by historical factors. However, unless the capital account is closed (which means that the private sector cannot exchange currencies and buy and sell assets internationally), there will be small fluctuations around the aimed fixed rate as declared by the central bank. Traders of pegged currencies profit from these fluctuations by betting, in most cases, that the peg will hold.
Why does a nation maintain a fixed currency regime?

In most cases the purpose is controlling inflation. Since government traditions in emerging markets are weak, political incentives for inflating the money supply strong, and the independence of monetary authorities is limited, or non-existent, inflation can become rampant and uncontrollable by the traditional method of raising the interest rates. As the public expects prices to go up, and press for higher wages in return, firms raise prices, and a feedback loop based on the psychological attitude of market participants can last indefinitely, doing massive harm to the economic health of a nation.

Usually, the government which created the inflationary phase is unwilling to solve the problem, and as it gets replaced at elections, the new government is handed over a situation which demands radical solutions. One of these radical solutions is the currency peg that we’re discussing in this article; by instituting it, the government is making a clear, irreversible, and reliable commitment to keeping any growth of money supply beyond that of the controlling central bank limited by the actual inflow of foreign currency into the nation through external activities. In other words, the printing presses of the pegging nation will be used only as often as that of the controlling nation which is often a developed world country with a credible and well-established policy.

Sometimes central banks and governments introduce pegs in preparation for a monetary union. Since the currency of the pegging nation will be abolished in time, it is beneficial to allow the public to get used to the new unit of value by maintaining a peg, while the new regulations and institutions are being built. The ERM (European Exchange Rate Mechanism) which preceded the launch of the Euro, or the present Danish peg, are examples of this kind of regime.

It is also possible that a peg be maintained for purely political reasons, with only limited economic justifications. In the case of the Gulf Arab States, and their much publicized, and criticized dollar pegs, the main benefit is the political and military support of the U.S. These nations have a sufficiently favorable current account position to build up considerable forex reserves, and as they are not exporters, they do not need to maintain a low exchange rate to help their trade income. Although the dollar peg is useful for controlling inflation sometimes, at other times the monetary policy of the U.S. can be highly inflationary, negating this benefit. But as the Gulf States mainly seek the political benefits of maintaining their pegs, this issue is mostly ignored by them.

Pegs can also be introduced temporarily in response to currency crises, without any relationship to inflation. Usually such regimes are removed in time. HK and Malaysia, for example, both introduced a fixed currency regime in response to the massive speculative attack during the Asian crisis of 1998.
Advantages and Disadvantages

Just as the rationale justifying a currency peg differs from case to case, the benefits and shortcomings of pegged currencies will be different in different scenarios. But there are two obvious features that are present in every case: the loss of independence by the pegging central bank, and the stability and credibility granted to the currency by the adoption of the new regime.

The advantages of the peg lie in its clarity and predictability. Its disadvantage, on the other hand, is its inflexibility in adapting to economic events. Unless government authorities have the wisdom to gradually readjust or remove the peg if conditions require as much, pegs which cannot be maintained can lead to currency crises involving large devaluations. There are other, more complex problems caused by exporter pegs, but this is out of the scope of this article.
Trading Fixed Currencies

Trading a fixed currency requires a good understanding of fundamental factors. Technical analysis is not very useful, because fluctuations of the rate lack continuity, liquidity is low, and there’s not enough data to feed to the indicators in order to generate timely and meaningful signals. Also, the actors that take part in the trading of the fixed currency are usually large players with big pockets whose choices are less sensitive to technical methods and strategies.

There are two ways of trading pegged currencies. One strategy involves exploiting routine short term fluctuations which may have all kinds of causes. These fluctuations are more frequent, but they always return to the official value of the peg, and can easily be exploited for profits. In this case, the trader will bet that the peg will hold, will enter a position in accordance, and will await, indefinitely, that intervention, or ordinary market dynamics bring the quote to where it is expected to be. The other strategy requires the identification of crisis-prone economies, and opening of positions that require that the peg be tested severely, or even be broken. This is a long-term method where profitable economic configurations are rarer. However, as demonstrated by George Soros’ bet against the British peg, such strategies can sometimes be extremely profitable and successful if built on solid fundamentals.

In both methods, a good understanding of fundamentals is a must. The trader must always keep an eye on currency in- and outflows, balance of payments statistics, and more importantly, on the official statements of government and monetary authorities. If the statements are backed by a healthy surplus and a credible intervention policy, the peg can be traded with confidence on a short term basis. If the central bank lacks the reserves to intervene to maintain the fixed regime, or if the government is unsure about the ultimate direction of economic policy, one must be careful about the size and scope of one’s positions while trading the peg.

For a reasonably knowledgeable trader, trading pegs can be lucrative and relatively simple and easy. But it is wrong to think of this trading strategy as being risk-free. While the small profits made in short term trading can be very lucrative, if we’re trading blindly, with eyes closed to fundamentals, a collapsing peg can wipe out the gains of weeks or months in a few hours or days. So although this strategy is safer, the necessity of diligent study and careful analysis is by no means diminished.
Some Examples

[IcemanSC]

Thanks for the post.