Currency peg

When a country tries to keep its currency trading at a certain exchange rate, or within a tight range against another currency, this is known as a “currency peg”.

When a country tries to keep its currency trading at a certain exchange rate, or within a tight range against another currency, this is known as a "currency peg". In most cases, currencies are pegged to the US dollar. In the case of China, pegging its currency (the yuan, or renminbi) to the dollar worked out pretty well. In 1994, China fixed the yuan to the dollar at a rate of around 8.28 (representing a significant devaluation at the time).

It remained around this level until 2005, when it moved to pegging the renminbi to a "basket of currencies" that included the euro and the yen. Within a few years, the renminbi had strengthened against the dollar somewhat, although the authorities continued to exert a tight grip.

Maintaining the peg meant that China's exports remained very cheap, driving large trade surpluses with the US (and the rest of the world), and helping to create rapid GDP growth in China. However, as with most attempts to control or suppress markets, it had significant unintended consequences.

In order to keep the renminbi artificially weak, China effectively had to print money to sell in exchange for dollars and other currencies. That in turn caused massive growth in the domestic money supply, which meant that credit was far too readily available, which has resulted in China having far too much debt relative to GDP.

Meanwhile, as growth has slowed, and its current-account surplus (whereby a country exports more than it imports and gets more money from abroad than it sends out) shrinks, or even becomes a deficit, China's exchange rate may no longer be undervalued indeed, it may be overvalued.

This could force China to drop the peg altogether and allow the renminbi to "free float", finding its own level. That would have a hugely disruptive impact on both the global economy and financial markets.

Recommended

Shrinking credibility leaves sterling resembling an emerging-market currency
Currencies

Shrinking credibility leaves sterling resembling an emerging-market currency

UK monetary policy and the effects of Brexit are undermining confidence in sterling – it is increasingly resembling an emerging-market currency.
8 Jun 2022
What the UK’s no-confidence vote means for the pound
Currencies

What the UK’s no-confidence vote means for the pound

Boris Johnson is to face a vote of confidence in Parliament after a group of Conservative MPs turned against him. Saloni Sardana looks at what it migh…
6 Jun 2022
Could a stronger euro bring relief to global markets?
Currencies

Could a stronger euro bring relief to global markets?

The European Central Bank is set to end its negative interest rate policy. That should bring some relief to markets, says John Stepek. Here’s why.
24 May 2022
Despite the crypto crash, bitcoin still has a bright future
Bitcoin & crypto

Despite the crypto crash, bitcoin still has a bright future

Cryptocurrencies have crashed hard, with bitcoin down by more than 50% from its peak. But, says Dominic Frisby, bitcoin still has a future – it is the…
19 May 2022

Most Popular

UK house prices are definitely cooling off – but are they heading for a fall?
House prices

UK house prices are definitely cooling off – but are they heading for a fall?

UK house prices hit a fresh high in June, but as interest rates start to rise, the market is cooling John Stepek assesses just how much of an effect h…
30 Jun 2022
How to invest in copper, the most important metal in the world
Industrial metals

How to invest in copper, the most important metal in the world

As the world looks to electrify and try to move away from fossil fuels, copper looks set to be the biggest beneficiary. But how can you invest? Rupert…
30 Jun 2022
Don’t try to time the bottom – start buying good companies now
Investment strategy

Don’t try to time the bottom – start buying good companies now

Markets are having a rough time, so you may be tempted to wait to try to call the bottom and pick up some bargains. But that would be a mistake, says …
1 Jul 2022