Pegging to a 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 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. 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 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 . 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 . 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 . 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 , 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. The pursuit of high-inflation irrelevant in the determination of their prices arithmetic average method, in which there is monetary policy in a pegged exchange rate in any one currency. a bias toward appreciation, should be adopted. regime has often resulted in frequent deval- Regardless of the method by which the If their primary concern is with maintaining uations or even complete abandonment of weights are derived, the basket composed the real (price level adjusted) effective ex- such a regime. (For such high-inflation coun- from trade weights can never be perfect, change rate in the face of rising prices, they tries, the benefit of free floating becomes because the impact of an exchange rate may prefer the first arithmetic average method, correspondingly greater). change on the policy objective cannot be in which there is a bias toward (nominal) Against the loss of discretionary monetary precisely predicted. In recognition of this, depreciation. Finally, if the primary concern policy, a rule-governed regime has the com- some countries have used the SDR as an is with the maintenance of the pre-determined pensating advantage that it frees the author- accessible and practicable proxy for the theo- currency weights, the geometric average ities from the need to make decisions on retically perfect basket. The SDR is partic- method may be preferred. The choice of a money supply and exchange rate constantly, ularly attractive when the shares of the cur- valuation method makes a large difference in thus freeing up resources, eliminating unnec- rencies that constitute it reflect fairly closely the value of the pegged currency over a essary uncertainty, and lessening the scope a country's pattern of trade and payments period of years. (This was reflected in the for costly policy errors. A rule-governed (the SDR currently comprises the US dollar, July 1984 decision by Norway to switch to regime is also likely to result in greater deutsche mark, , French franc, the geometric average method from the sec- monetary discipline and credibility. In any and ). Moreover, because the ond arithmetic average method, under which case the value of discretionary monetary Fund quotes the value of the SDR in terms the weight of the then-appreciating US dollar policy may be limited in small, open economies of most major currencies on a daily basis, the was rapidly increasing in Norway's basket.) that are typically subject to disturbances (e. g.,

42 Finance & Development I September 1986

©International Monetary Fund. Not for Redistribution crop failures or recession in the industrial essary to support that rate. Thus a strict Under a basket peg, as in a free floating countries) over which they have little control. basket peg policy is not practicable. But, if regime, the authorities may need to provide This trade-off between rules and discretion the exchange quotation is made less fre- forward facilities if there is no forward market becomes important in the resolution of op- quently (e.g., once a day), a minimum margin for the home currency. This is not the case erational issues arising out of the administra- on either side of parity is needed to allow the under a single currency peg, where forward tion of a basket peg policy. official rate to deviate from the theoretical transactions can, in principle, be conducted rate. If the quoted rate is allowed to deviate in terms of the intervention currency with Operation of a basket peg considerably from the theoretical rate, there which the home currency is convertible at a The operation of a basket peg involves is an incentive for foreign exchange dealers fixed parity. The guaranteed convertibility several issues that do not arise in the oper- to make speculative profits by selling with the intervention currency at a fixed par ation of a single currency peg. They include or short buying. While may not rate allows the home currency to share the the public disclosure of the basket, the fre- be harmful under all circumstances, the au- characteristics of the intervention currency. quency of quotations, and the width of margins thorities may desire to prevent the dealers Under a basket peg, however, there is no

Calculating the value of a currency basket

In the following example, it is assumed that the basket consists of the US rate of each currency is expressed in US dollars per unit of currency, that dollar (with a share of 50 percent), the deutsche mark (35 percent), and is, 1 for the US dollar, 0.5 for the deutsche mark, 0.004 for the Japanese the Japanese yen (15 percent) and that the exchange rates in the base yen, and 0.1 for the home currency. Second, the number of units of each period in terms of 1 US dollar are: 2 deutsche mark, 250 Japanese yen, currency in the basket is determined by finding the value of an unknown and 10 units of the home currency. (d,) such that the product of d, and the dollar exchange rate constitutes Suppose that the deutsche mark depreciates to 2.5 and the Japanese the desired share. In this example, we have yen appreciates to 200 per US dollar. In this case, defining an increase in (1 x dx) + (0.1) = 0.5, the index as a depreciation against the dollar, the new exchange rates can (0.5 x d ) + (0.1) = 0.35, be expressed in terms of index numbers as: 100 for the US dollar, 125 2 and (0.004 x d ) + (0.1) = 0.15, for the deutsche mark, and 80 for the Japanese yen. The new exchange 3 rate index of the home currency can be found by taking (1) the geometric thus obtaining di = 0.05, d2 = 0.07, andd3 = 3.75. The standard basket average, (2) the arithmetic average, or (3) the arithmetic average of the will then comprise 0.05 units of the US dollar, 0.07 units of the deutsche inverses, that is the dollar per unit of foreign currency, of the indices of mark, and 3.75 units of the Japanese yen. This composition of the basket the three currencies in the basket: will remain the same regardless of subsequent exchange rate changes Geometric average: (lOO^X^0-35)^15) = 104.56 until the authorities decide to change it deliberately. Arithmetic average (I): (100x0.5) + (125x0.35) + (80x0.15) = 105.75 Calculating its value Arithmetic average (II): Once we know the currency units in the basket, the vafase of the home currency in terms of the US dollar at a subsequent date can be calculated x0 5 + x0 35 + 15 as the sum of the values of the three currency components* fat ttie example (l55 - ) fe ' ) O' ) above, if the new exchange rates in terms of the US dollar are 1 for the US dollar, 0.4 for the deutsche mark, and 0.005 for the Japanese yen, the Thus the depreciation shown by the geometric average method is 4.56 new exchange rate of the home currency would be calculated as follows: percent, the arithmetic average method (I) 5.75 percent, and the arithmetic average method (II) 3.36. (1 x 0.05) + (0.4 x 0.07) + (0.005 x 3.75) « 0.09675 This represents a 3.36 percent depreciation, the same as the result under The operation of a standard basket the second arithmetic average method. This follows from the fact that, since the currency units are fixed under the standard basket method, an Composing the standard basket increase in the value of a component currency in terms of the feterventoi If we use the same currencies as in the above illustration, the standard basket can be composed in the following manner. First, the initial exchange currency means an increase in the share of that currency in the basket.

around the parity value of the basket in terms from knowing what the theoretical exchange link between the home currency and the of the intervention currency. These opera- rate is by not disclosing the composition of currencies in the basket. The only way to tional issues arise from the fact that the the currency basket. This is why most of the establish this direct link and thus allow forward exchange rate of the home currency con- tailor-made baskets are not publicly disclosed. facilities under a basket peg arrangement is stantly changes in terms of the currency that An additional complication arises from the to peg the home currency to a basket that is is used to intervene in the market to maintain fact that it is easy for dealers and other composed of fixed units of currencies. Such the value of the basket, but the rate is still participants in the a basket is known as the "standard" basket; dictated by a specific exchange rate rule. to estimate the undisclosed currency shares the SDR and the ECU are two best known If the authorities desire to adhere strictly in the basket by observing the movements examples of this type of basket. Under the to a basket peg rule under these conditions, of the exchange rate of the home currency standard basket method, the home currency they must continuously calculate and quote against all others. The authorities need to retains all the currency characteristics of the the exchange rate against the intervention vary margins from time to time, in an unpre- component currencies, thus forward trans- currency and be ready to sell or buy whatever dictable fashion, if they also desire to eliminate actions in the home currency can be made amount of the intervention currency is nec- this possibility. by forward sale or purchase of the component

Finance & Development I September 1986 43

©International Monetary Fund. Not for Redistribution currencies in their exact composition in the rate regime governed by the rules of a basket Conclusion basket, provided there is a well-functioning peg. Similarly, keeping the basket undisclosed The preceding discussion suggests that the forward market for all of them. This composite may signal a lack of commitment on the part operation of a basket peg can be quite flexible. currency or basket can be determined by of the authorities to pursue a rule-governed At one extreme is a policy of pegging to a finding the number of units of each currency exchange rate policy and may even increase publicly disclosed basket with narrow margins that would give that currency the desired the temptation for overvaluation. On the other and infrequent adjustments; on the other weight in the basket; the value of the basket hand, a policy of pegging the home currency extreme is a policy of pegging to a publicly in terms of the intervention currency, say to a publicly disclosed basket with a narrow undisclosed basket with wide margins and the dollar, at a subsequent date can be given margin accompanied by little adjustment may frequent adjustments. Under such conditions, by the sum of the dollar values of the currency impose on the authorities a firm commitment there is a fine line between a basket peg and components at that date (see box). to abide by such a policy and reduces the a managed float. In the current system of In order to retain some degree of monetary temptation for overvaluation. floating exchange rates, both the basket peg discretion, the authorities may want to main- and the managed float can help stabilize tain a wide margin around the parity value. effective exchange rates. However, they dif- They may also want to make discrete ad- fer in the extent to which they allow policy justments in the value or the composition of Shinji Takagi discretion. Our discussion suggests that the the basket in order to offset a loss of com- a Japanese citizen, is an benefits of a basket peg are likely to be petitiveness or to accommodate a change in Economist in the Fund's greater, if a country has a less diversified the structure of the country's trade. Too wide Research Department. He production, is well integrated with the global a margin or too frequent an adjustment, holds a PhD in economy and thus more vulnerable to external however, will make a basket peg behave from the University of disturbances, and lacks the manpower to more like a managed float. Although a mini- Rochester, and has properly manage a more discretionary ex- published articles on mum margin and occasional adjustments are change rate system. As long as the current and necessary for the smooth operation of a international finance. global exchange rate system continues, a basket peg, their excessive use may lead to basket peg is likely to remain a viable and a loss of monetary discipline and credibility useful exchange rate regime for smaller that are the key ingredients of an exchange economies. HD

A New IMF/ODI Publication. . . Problems of International Money, 1972—85 Edited by Michael Posner

, ,,,o volume focuses on the changing relationship between the private and institutional participants in the international monetary system over the past decade and comprises the papers presented at a seminar that was jointly organized by the International Monetary Fund and the Overseas Development Institute. Eight chapters—by David Llewellyn, Q.G. Johnson, Tony Killick, Michael Dooley, Azizali F. Mohammed, David Lomax, Ernesto Zedillo, Stephany Griffith-Jones, and Loukas Tsoukalis—review the evolution of the system, the problems that have emerged and the questions that have arisen, and look ahead to improvements that might be made to the existing system.

Available from Publications Unit*Box A-863 International Monetary Fund-700 19th Street, M.W. Washington, D.C. 20431, US A • Telephone (202)623-7430

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