Fixed Exchange Rate

A Fixed Exchange Rate (also known as a 'pegged exchange rate') is a currency valuation regime where a country's government or central bank ties its official exchange rate to another country's currency or the price of gold. The purpose is to keep the currency's value stable against a chosen anchor. This is the polar opposite of a floating exchange rate, where the relentless forces of supply and demand in the foreign exchange market determine a currency's price from moment to moment. To maintain this “peg,” the central bank must stand ready to intervene. It uses its foreign exchange reserves (stockpiles of foreign currency) to buy its own currency if it weakens or sell it if it becomes too strong. This constant management aims to provide economic stability and predictability, but it comes with its own significant challenges and risks. Historically, the most famous fixed system was the gold standard, where currencies were directly convertible into a set amount of gold.

Think of a fixed exchange rate as a promise from a country's central bank: “We guarantee that one of our currency units will always be worth X units of another currency (say, the U.S. dollar).” Keeping this promise is a full-time job.

The central bank acts like a vigilant market participant, ensuring the price never strays from the target.

• If the currency is too strong: Imagine a flood of foreign investment enters the country, increasing demand for the local currency and pushing its price up. To counteract this, the central bank steps in and sells its own currency on the open market, buying the foreign anchor currency. This increase in supply brings the price back down to the pegged level.
• If the currency is too weak: Now, imagine a recession hits, and investors start pulling their money out, selling the local currency and causing its price to fall. The central bank must defend the peg by buying up its own currency using its precious foreign exchange reserves. This decrease in supply props up the price, bringing it back to the target.

This balancing act requires a country to hold vast foreign reserves. If the reserves run low, the promise becomes impossible to keep, and the market knows it.

Pegging a currency is a major strategic decision with significant trade-offs. It offers the allure of stability but demands a steep price in policy freedom.

• Certainty for Business: This is the biggest selling point. It eliminates currency risk for importers, exporters, and international investors. A company selling goods to a pegged country knows exactly how much it will earn in its home currency, making planning and pricing much simpler.
• Taming Inflation: A country with a history of high inflation can peg its currency to that of a more stable, low-inflation economy (like the U.S. or Germany). This effectively “imports” the anchor country's monetary discipline and can help control domestic prices.
• Encouraging Investment: The predictability of a fixed rate can attract foreign direct investment, as companies are more confident in the stability of their returns.

• Loss of Monetary Autonomy: A central bank in a pegged system loses its most powerful tool: the ability to set its own interest rates to manage the domestic economy. If a recession hits, it cannot lower rates to stimulate growth if doing so would threaten the currency peg. The peg becomes the only priority.
• Vulnerability to Attacks: A fixed rate can be a tempting target for currency traders. If speculators believe a peg is unsustainable, they can launch a speculative attack by massively selling the currency. This forces the central bank to burn through its reserves to defend the peg. The most famous case is when George Soros “broke the Bank of England” in 1992 by betting against the British pound, forcing its exit from a European fixed-rate mechanism.
• Painful Adjustments: If a country can no longer defend its peg, it is forced into a devaluation—a sudden and often large downward adjustment of the official exchange rate. This can cause economic chaos, spike inflation, and wipe out foreign investors' holdings. The pre-crisis alternative, a revaluation, is an upward adjustment of the peg.

For a value investing practitioner, a fixed exchange rate is a double-edged sword. It can simplify analysis on the surface but often hides deep, underlying risks.

At first glance, a fixed exchange rate is great news. When you analyze a company based in a country with a pegged currency, you don't have to worry about wild currency swings messing with its international sales or costs. This makes forecasting its earnings and cash flows—a key step in determining its intrinsic value—seem much more straightforward. However, the stability is only as strong as the government's ability to maintain it. A savvy value investor must look beyond the company's balance sheet and assess the macroeconomic picture:

• Is the peg credible? Check the country's economic health. Are its foreign reserves large and stable, or are they dwindling? Does the country have a persistent current account deficit, meaning it's buying much more from the world than it's selling? These are red flags that the peg may be under pressure.
• The Devaluation Trap: The biggest risk is a sudden devaluation. Imagine you invest in a wonderful company in Country X, whose currency is pegged 1:1 with the U.S. dollar. The company is profitable and growing. But if Country X's economy falters and it is forced to devalue its currency by 30%, your investment, when converted back to dollars, instantly loses 30% of its value. This single event can erase years of solid business performance.

In conclusion, while a fixed exchange rate can provide a helpful layer of predictability, it should never be taken for granted. A true value investor treats a currency peg not as a guarantee, but as another risk factor to be carefully analyzed. The promise of stability is appealing, but the penalty for when that promise is broken can be severe.