Pegged and managed currencies: CNY, HKD, SAR, AED and the risks of de-pegging
Understand how fixed and managed exchange-rate regimes work, how they are defended, and how to read warning signs before a peg breaks.
What you will learn
- The main exchange-rate regimes, from a hard peg to a managed float, and how each one is defended.
- How the Hong Kong dollar, Saudi riyal, UAE dirham and Chinese yuan are managed in practice.
- How to use forward prices to see whether the market doubts a peg.
- Why peg trades combine small, steady gains with rare, very large losses.
Explanation
An exchange-rate regime is the set of rules a country uses to manage the price of its currency. Most major currencies float freely; many others do not.
The main regimes
- Hard peg / currency board: the currency is fixed to an anchor currency (usually the US dollar), and the money supply is backed by reserves of that anchor currency. Local interest rates must then follow the anchor's rates.
- Conventional peg: a fixed rate defended with reserves and interest rates, without strict currency-board rules.
- Band or crawling peg: the currency may move inside a band, or the central rate is adjusted step by step.
- Managed float: the market sets the price, but authorities steer it with reference rates, capital controls or intervention.
Four examples
Hong Kong dollar (HKD): under the Linked Exchange Rate System (in place since 1983), the Hong Kong Monetary Authority (HKMA) commits to sell HKD at 7.75 per US dollar and to buy HKD at 7.85 per US dollar. These commitments are called convertibility undertakings. When USD/HKD reaches 7.85, the HKMA buys HKD. The banking system's balance at the HKMA (the Aggregate Balance) then shrinks, Hong Kong interest rates rise, and the higher rates pull the rate back into the band. At 7.75 the process runs in reverse.
Saudi riyal (SAR) and UAE dirham (AED): both are pegged to the US dollar, the riyal at 3.75 per dollar since 1986 and the dirham officially at 3.6725 per dollar since 1997. Both central banks hold large dollar reserves and generally follow US rate decisions.
Chinese yuan (CNY): the yuan is a managed float. Each trading morning the People's Bank of China (PBOC) publishes a central parity (also called the fixing or midpoint), and onshore trading is allowed only within a band around it (2% either side under the rules in force since 2014; check the current rules). Offshore yuan (CNH) trades mainly in Hong Kong and moves more freely; a wide CNY–CNH gap can signal pressure.
Why pegs break
A peg lasts as long as the central bank has the reserves and political will to defend it. Pressure builds when the economy needs a different interest rate from the anchor, when export income falls (for example oil revenue), or when capital flows out. Well-known breaks include the British pound leaving the European Exchange Rate Mechanism (ERM) in September 1992, the Thai baht float in July 1997, and the Swiss National Bank (SNB) ending its minimum rate of 1.20 francs per euro on 15 January 2015. Each time the currency moved very far within hours or days, and many stops were filled far from their levels.
Warning signs
- Falling reserves reported by the central bank month after month.
- Forward points (the difference between the forward and the spot rate) that are much larger than the interest-rate difference explains.
- A parallel or offshore rate that trades well away from the official rate.
Worked example
Hypothetical example: USD/SAR spot = 3.75. Assume a one-year SAR interest rate of 6% and a one-year USD rate of 5% (invented round numbers). Fees, spreads and taxes are excluded.
Step 1, fair forward from interest rates (covered interest parity, introduced in the swap lesson of this course): forward = spot × (1 + SAR rate) ÷ (1 + USD rate) = 3.75 × 1.06 ÷ 1.05 = 3.7857.
Step 2, compare with the market: assume the quoted forward is 3.80. Extra premium = 3.80 ÷ 3.7857 − 1 = 0.38%: a price for de-peg risk beyond the interest difference.
Step 3, asymmetric payoff: an investor holds SAR 3,750,000 ($1,000,000) to earn 1% extra interest: about $10,000 per year. After a hypothetical 20% devaluation to 4.50 per dollar, the holding is worth 3,750,000 ÷ 4.50 = $833,333, a loss of $166,667. That loss equals about 16.7 years of the extra interest.
Common mistake
Practice activity
On paper, take a hypothetical currency XYZ pegged at USD/XYZ = 10.00. Assume a one-year XYZ rate of 8% and a USD rate of 5%. The quoted one-year forward is 10.80. Calculate (a) the fair forward from interest rates and (b) the extra premium. Then write one sentence on what the extra premium suggests.
Show solution
(a) 10.00 × 1.08 ÷ 1.05 = 10.2857. (b) 10.80 ÷ 10.2857 − 1 = 0.050, so about 5.0% extra premium. The market is pricing a meaningful probability that XYZ will be devalued within a year; this is a warning sign, not a forecast.
Limitations: real forward markets for pegged currencies can be thin or restricted, and capital controls can distort forward prices.
Key takeaways
- HKD trades in a 7.75–7.85 band, SAR and AED are pegged to the US dollar, and CNY is a managed float around a daily central parity.
- Pegs are defended with reserves and interest rates; they break when reserves or political will run out.
- Forward premiums above the interest-rate difference, falling reserves and wide offshore gaps are warning signs.
- Peg trades offer small regular gains against rare, very large losses that stops may not limit.
Next step
In the next lesson you will look at floating emerging-market currencies, where inflation and capital flows drive large moves, using the Turkish lira as a case study.
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