1. There are several reasons why some currencies are pegged, and others are not. Currencies are managed by Central Banks of respective countries. The main objectives of Central Banks are to maintain price stability and to facilitate long term economic growth in their respective countries. Exchange rates play a key role in price stability and growth. Countries that have strong export-oriented economies have flexibility in choosing exchange rate regimes. Many such countries use pegged currencies in order to avoid impact on exports from currency volatility.
2. How do Countries manage foreign reserves?
Most countries do not have a Fully Convertible domestic currency. This means that the country’s Central Banks keep the bulk of the foreign exchange reserves of that particular country. In such countries, citizens are not allowed to keep much foreign exchange beyond a certain limit. If any individual has foreign exchange, then that individual is obligated to convert the extra foreign exchange beyond a defined limit to the domestic currency. However, there are exceptions created for certain entities, particularly for importing and exporting organizations.
When any foreign entity transfers forex into a country, that country’s central bank takes the foreign exchange and equivalent amount of domestic currency is transferred into the designated account of that entity.
The Central Bank accounts for the vast quantity of foreign reserves even in countries that have a fully convertible domestic currency.
3. Balance of Payments equation
Because of the above dynamics, the change in the foreign reserves of the central bank match the change in foreign exchange related transactions of a country. This is what is reflected in the commonly known equation:
Change in Central Bank Reserves = Change in Current Account + Change in Capital Account +accounting reconciliation
The change in Current Account reflects the change in foreign exchange resulting primarily from trade. Countries that export more than they import, such as China, have a Current Account Surplus while countries that import more than export, such as India or the USA, have a Current Account Deficit.
The change from Capital Account reflects the changes in foreign exchange stemming primarily from foreign investments into and out of the country. Countries where foreigners invest more than the amount that domestic residents send abroad, have a Capital Account surplus and those where residents invest more internationally than what foreigners invest into the country have a Current Account Surplus. Account reconciliation is a smaller amount as compared to the other parts of the equation.
The two total changes in these two account heads roughly equals the change in forex reserves held by the Central Bank of that country. In years, where there are extreme macroeconomic developments, the existing reserves of the central bank can be used to ensure critical imports from abroad can take place.
4. How do Central Banks decided whether to have a Free float or pegged currency?
Let us go back to the equation that we discussed earlier:
Change in Central Bank Reserves = Change in Current Account + Change in Capital Account +accounting reconciliation
The structure of the Current Account is less flexible year on year for different countries. This is because several components of the Current Account deal with necessities such as oil and gas, food, and certain types of electronics. However, the changes in Capital Account are more dependent on global financial market conditions. Therefore, countries that have Current Account Surplus (exports exceeding imports) generally have greater flexibility in foreign exchange policies.
Many of these countries want to ensure that the main currency in which their exports are denominated does not have a volatile relationship with the domestic currency. In order to accomplish this, the country pegs its currency to this export-oriented currency.
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