Pegging to a currency basket The technical issues behind the choice, composition, and operation of a basket peg under a system of floating exchange rates Shinji Takagi JT ollowing the generalized floating of the these conditions, when a country decides not drawing right (SDR) and, later, the European world's major currencies in 1973, a number to float independently, it must also choose Currency Unit (ECU). of smaller countries began pegging the value the appropriate standard to which it wishes Although at least one country adopted an of their currencies to an average value, or to peg its currency. exchange rate system similar to a basket peg basket, of selected foreign currencies. At the When the world's major currencies began in the interwar years of floating exchange end of 1985, 43 member countries of the to float in early 1973, most small countries rates, the basket peg is a relatively new Fund maintained such basket peg arrange- initially continued to peg their currencies to mechanism that came into being in the wake ments. Taking into account countries that the single currency that they had previously of generalized floating after 1973. The exten- adopted and then abandoned a basket peg, used to intervene in the market to support sive use of the basket peg in recent years the total number of countries with such ar- the fixed value of their currencies (mainly, can be explained by the greater diversification rangements during 1973-85 was 63. the US dollar, French franc, and pound ster- in international trade that has increased the ling). Some of these countries soon began to cost of a single currency peg, as well as by Why a basket peg recognize, however, that the benefit of main- the availability of a well-defined concept of an taining exchange stability against the inter- effective exchange rate—allowing them to While the ability to maintain a market- vention currency was, to varying degrees, measure the "average" exchange rate when determined exchange rate is a benefit of free offset by the cost of greater fluctuation vis- currencies are floating against each other— floating shared by all countries, it can be a a-vis other major currencies. As a result, that has helped in measuring the benefit of a relatively costly arrangement for small coun- several countries began to manage system- basket peg to policy makers. tries, with their smaller volume of foreign atically the movements of the home currency exchange transactions, relatively inelastic trade against currencies that were thought impor- Choosing a basket flows, and less developed financial markets. tant, so that the home currency would neither The choice of a basket depends upon the These countries, therefore, have a greater float independently nor be pegged to any exchange rate policy objective of the author- incentive to choose a fixed over a freely single currency. In practice, this was done ities. This objective may be defined in terms floating exchange rate. In the current envi- by pegging the home currency to the so- of a readily identifiable relative price variable, ronment, however, when most major curren- called effective exchange rate index (i.e., a such as the terms of trade or the real exchange cies are floating independently, no small coun- weighted average of bilateral exchange rates), rate, or in terms of a macroeconomic variable try can maintain a strictly fixed exchange rate or to a basket of currencies. The currency such as the balance of trade or, more impor- system: a decision to peg the currency to baskets included both country-specific bas- tant, the balance of payments. Once the any major currency inevitably leads it to float kets (e.g., based on bilateral trade flows) and objective is defined, the choice of currencies against all other floating currencies. Under ready-made baskets, such as the special and the weights to be assigned to them in Finance & Development I September 1986 41 ©International Monetary Fund. Not for Redistribution the basket can be made on the basis of the SDR peg offers a simple means of determining Basket as an exchange rule relative importance the authorities attach to the value of a home currency against those exchange rate stability against various cur- major currencies. Several studies conducted Regardless of the choice of a valuation rencies in the light of the chosen policy in the Fund have indicated that, in practice, method, the effect of a basket peg is to objective. The greater the need for stability pegging to the SDR is more effective than minimize the extent of exchange rate fluctua- vis-a-vis a particular currency, the greater its pegging to a single currency in stabilizing a tion against all currencies. For example, in a relative weight in the basket. Determining reasonably defined effective exchange rate in basket containing the dollar, the deutsche the exact weights is a complex exercise. most developing countries. mark, and the yen, when the yen appreciates Some countries have used an econometric against the dollar and the deutsche mark, the model, such as the Fund's Multilateral Ex- Valuation of basket home currency that is pegged to this basket change Rate Model (MERM) to assign ap- The choice of currency weights in a basket will also appreciate against both these cur- propriate weights to individual currencies in does not in itself determine the value of the rencies, though the extent of appreciation of their baskets. (The MERM is a general home currency. The same set of weights can the home currency will be less than that of equilibrium model that is designed to assess give different values depending on which of the yen. In this respect, a basket peg resem- the trade effects of exchange rate changes in two methods is used to weight changes in bles a managed float. The crucial difference the world economy. It is disaggregated into the component currencies. Under one method between these two exchange rate regimes, 18 countries or groups of countries and six (the arithmetic average method), the currency however, is that under a basket peg the value classes of goods.) The use of this method weights are variable and, more important, of the currency is automatically determined has the advantage that it takes account both the way the exchange rate index is defined by the rules governing the operation of the of the direct effect on a country's trade and determines how those weights change: if an basket, while under a managed float the payments of exchange rate fluctuations against increase in the exchange rate index is defined authorities have to take discretionary action the currencies of bilateral trading partners as a depreciation in terms of the intervention to adjust the value. and of the indirect effect of movements in currency (first arithmetic average method), Under a rule-governed exchange rate re- the currencies of other countries that are increasing weight is given to a depreciating gime, such as a basket or a fixed peg, the competing in the same markets. This method currency; if an increase is defined to be an authorities give up control over the money also allows the authorities to distinguish among appreciation (second arithmetic average supply in order to retain control over the different classes of commodities that have method), increasing weight is given to an exchange rate. (In fact, the same kind of different price elasticities of supply and de- appreciating currency (see box for an expla- trade-off exists under free floating, where the mand. Of course, a question remains as to nation of these methods). Under another authorities give up control over the exchange the feasibility of constructing such a general method (the geometric average method), the rate in order to retain control over the money equilibrium model that is capable of replicating initial currency weights can be maintained supply.) A rule-determined exchange rate will reality accurately. In practice, most countries indefinitely and the value of the basket is largely determine the domestic price of traded have decided not to use this method on the independent of the way the exchange rate goods and the nominal quantity of money that grounds that it is either not feasible or credible index is defined. is consistent with that price level. If domestic and have decided instead to use simple bilat- Given the same movements in the ex- credit expands too rapidly, for example, there eral trade shares to weight their baskets. change rates of the component currencies, will be an offsetting outflow of reserves. This Many suggestions have been made to give the first arithmetic average method results is a binding constraint on monetary policy greater economic validity to the use of such in the most depreciated value, the second under a pegged exchange rate regime, be it bilateral shares. For example, it has been method in the least depreciated value, and a single currency peg or a basket peg. The pointed out that the share of trade in homo- the geometric average method in an inter- only difference is that, under a basket peg, geneous goods (such as agricultural products mediate value. In the light of these different the authorities can choose their own desired and minerals) should be excluded from the implications of valuation methods, the choice long-run rate of inflation by the choice of a calculation, because the existence of a well among them should be made according to the basket. Under a single currency peg, the integrated world market for these commod- authorities' policy objective. If the primary inflation rate is determined by the country of ities tends to make the direction of trade concern is with price stability, the second the currency peg.