Questions4Thoughts

What is Currency Pegging?

Currency pegging is the idea of fixing the exchange rate of a currency by matching it’s value to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold or silver.

A fixed exchange rate is usually used to stabilize the value of a currency, with respect to the currency or the other valuable it is pegged to. Pegging a currency to another currency facilitates trade and investments between the two countries, and is especially useful for small economies where external trade forms a large part of their GDP. Pegging is also used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

£1 coin (Welsh design, 2000)

£1 coin (Welsh design, 2000)

The idea of pegging against gold started in the late 17th century when a new gold coinage was introduced in Great Britan based on the 22 carat fine guinea. Fixed in weight at 44.5 to the troy pound (1 troy pound = 12 troy ounce ≈ 373.24 gram) from 1670, this coin’s value varied considerably until 1717, when it was fixed at 21 shillings (equal to 1.05 pounds). Soon gold gained value over silver and merchants sent silver abroad in payments whilst goods for export were paid for with gold. As a consequence, silver flowed out of the country and gold flowed in, leading to a situation where Great Britan was effectively on a gold standard.

Series of 1917 $1 United States Bearer Note

Series of 1917 $1 United States Bearer Note

From 1792, when the Mint Act was passed, the dollar was pegged to silver and gold at 371.25 grains (1 grain = 64.79891 milligrams) of silver, 24.75 grains of gold (15:1 ratio). By 1837, the value of gold against dollars got changed slightly to 23.22 grains of gold (which shifted the ratio to 16:1). In 1862, paper money was issues without the backing of precious metals, due to the Civil War. Silver and gold coins continued to be issued and in 1878 the link between paper money and coins were reinstated. In 1900, the bimetallic standard was abandoned and the dollar was defined as 23.22 grains (1.505 g) of gold, equivalent to setting the price of 1 troy ounce of gold at $20.67. Gold coins were confiscated in 1933 and the gold standard was changed to 13.71 grains (0.888 g), equivalent to setting the price of 1 troy ounce of gold at $35.

In 1940, an agreement with the U.S.A. pegged the pound to the U.S. dollar at a rate of £1=$4.03. This value continued till 1949. On 19 September 1949 the British government had to devalue the pound by 30.5% due to the pressure of Second World War, which evaluated pound as £1=$2.80. This move prompted several other currencies to be devalued against the dollar, which included the Indian Rupees.

In 1898, the Indian rupee was tied to gold standard through British Pound. Prior to this, the Indian rupee was a silver coin (‘raupya’ in Sanskrit means silver), which made the rupee to be pegged at a value of 1 shilling 4 pence (i.e., 15 rupees = 1 pound). In 1920, the rupee was increased in value to 2 shilling (10 rupees = 1 pound). However, in 1927, the peg was reduced to 1 shilling and 6 pence (13.33 rupees = 1 pound). This peg was maintained until 1966, when the rupee was devalued and pegged to the U.S. dollar at a rate of 7.5 rupees = 1 dollar (at the time, the rupee became equal to 11.4 british pence). This peg lasted until the U.S. dollar devalued in 1971.

50 Indian Rupees

Modern 50 Rupee Indian Banknote

Officially, the Indian rupee has a market determined exchange rate. However, the RBI trades actively in the USD/INR currency market to impact effective exchange rates. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a ‘de facto’ controlled exchange rate. This is sometimes called a ‘dirty’ or ‘managed’ float. Other rates such as the EUR/INR and INR/JPY have volatilities that are typical of floating exchange rates. It should be noted, however, that unlike China, successive administrations (through RBI, the central bank) have not followed a policy of pegging the INR to a specific foreign currency at a particular exchange rate. RBI intervention in currency markets is solely to deliver low volatility in the exchange rates, and not to take a view on the rate or direction of the Indian rupee in relation to other currencies.

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