Pegged Currencies: Jump Risk Hiding in Plain Sight

Pegged currencies have seen somewhat of a resurgence of interest in recent months – whether it be larger than normal swings in the Chinese Yuan or the more nouveau issue of pegged crypto-currencies. What makes pegged currencies potentially so dangerous for investors is that they do not move 1pip up and 1pip down but rather they trade in jumps – moving 10% or more without giving risk managers any chance to hedge. With this in mind, we thought it the perfect time to have a closer look at some of the world’s pre-eminent pegged currencies and the risk associated with each.

USDCNY

Background

China introduced sweeping economic reforms in 1978 that led to 4 decades of phenomenal growth but also required a weaker Yuan to make their exports cheaper globally and underpin the economy. Managing the Yuan is a cornerstone of their economic policy, and it was strictly pegged to the USD at 8.28 till July 2005, but due to mounting pressures from trading partners, China changed to a “managed float” approach.

Maintenance of Peg

Although the official policy is to manage the price stability of the Yuan against a basket of currencies there have been occasions where it has been “re-pegged” to the dollar to smooth out volatility, especially when markets are stressed. The PBoC manages the Yuan by enforcing capital controls, strict foreign investment quotas, and a complex system that manages onshore trading and influences offshore yuan activity. These controls are structural and less flexible, so the PBoC allows the yuan to trade in a 2% range around a mid-point it fixes against the dollar each day (this mid-point can be adjusted by an undefined “counter-cyclical factor”).

Risks

The Onshore Yuan (CNY) and Offshore Yuan (CNH) usually trade very closely but because there’s less liquidity and state control of CNH, which means that during stressed times the spread between the two will widen, exposing investors to basis risk. In short, the above means that the true value of the Yuan is open to interpretation and the consensus is that it should be stronger but ultimately China needs a weaker currency to make its exports competitive without a flight of capital.

USDHKD

Background

The Hong Kong dollar has been famously pegged to the USD since 1983 (H$7.80=1 USD), moving in 2005 to a trading band of H$7.75-7.85 to accommodate for minor fluctuations. The peg has been an important aspect of Hong Kong’s history of financial stability, especially as it relates to serving as the financial hub for developed market investments into Asia over the past several decades. Following the Sino-British Joint Declaration and the subsequent transfer of governance of Hong Kong from the UK to China in 1997, Hong Kong has experienced an increasing loss of financial and civic independence. This has borne prevalent risks to the HKD peg to USD as market participants evaluate the safety of capital and the capability of the Hong Kong Monetary Authority (HKMA) to maintain the peg.

Maintenance of the peg

Much of the pressure on the HKD peg in recent decades has been a strengthening relative to the US dollar thanks to the rise of China in the 21st century and the corresponding inflow of Western investment. This has meant defending the H$7.75 lower boundary of the trading band for the HKMA, a much easier task than defending the upper boundary. As a result, the HKMA has built up USD reserves from $150bn at the end of the 2008 GFC to just shy of $500bn by the end of 2021, buoyed through the COVID pandemic by massive Hang Seng IPOs demanding HKD. However, USDHKD has recently returned to the top of its trading band for the first time in several years, with an accompanying $30bn+ drop in reserve assets in the first 4 months of 2022. This drop represents the most aggressive depletion in reserve assets going back to the start of the HKMA reserve asset data history in the early 90s, highlighting the risks to the peg.

Risks

A steep reduction in the overall freedoms of Hong Kong by China in recent months has led to fears that the city-state can no longer serve as the hub for Asian investment and finance that it once did. Additionally, growing political discord between China and the West (the US in particular) has added to fears that investment in a slowing Chinese and Eastern Asia economic complex is not warranted. The geopolitical tensions may also simultaneously disincentivize China from intervening in any way to save the peg. Another factor that may affect the peg stability is the diverging monetary policy between the US and Hong Kong, where the former will be focused on fighting against run-away inflation while the latter contends with a struggling economy that may crumble under the pressure of higher rates. Tellingly, the options market has signalled via higher implied volatility that there is a remote but growing risk of the peg becoming unhinged and succumbing to an unavoidable blow-out.

USDAED

Background

In 1997 the peg to the USD was introduced and has been maintained since at a level of 3.6725. Natural gas and petroleum products (oil) are a key export of the country and are hugely important for the country’s economy. As these commodities are priced in USD, it made sense for a nation that was hugely reliant on selling oil, to have a currency that avoided unnecessary volatility between its currency and the one it was receiving as payment. This has meant the UAE has attracted much in the way of foreign investments given increased investor confidence.

Maintenance of the Peg

The peg is maintained via the central bank which will always promise to convert one US dollar to 3.6725 Arab Emirates Dirhams and to do this, the central bank must have a large USD reserve, not an issue for the UAE which receives USD payments for oil sales. The UAE holds its USD reserves in treasuries and should they need to raise USD cash, they sell these treasuries in the secondary market. The CB will monitor the exchange rate relative to the USD value and should the currency fall below the peg, they will sell treasuries to generate USD and sell the USD to buy the AED. This reduces supply and restores the peg.

Risks

Risks exist should oil be priced in currencies other than the USD or if oil stops becoming a major export of the UAE. The latter seems very unlikely, but the former is an issue that the Ukraine-Russia conflict has raised. Should oil be priced in currencies other than USD, the UAE could continue to sell oil to USD buyers but would need to ensure the USD received is enough to continue to maintain the peg. Otherwise, the UAE could sell oil in currencies other than the USD, but the peg would need to become a function of a basket of currencies rather than just the single USD

EURDKK

Background

Danmarks Nationalbank (“DNB”) has employed a currency peg for the Danish Krone (“DKK”) against Europe’s pre-eminent currency since the early 1980s, firstly against the Deutschmark and then against the euro, where it has remained fixed at a rate of 7.46038 DKK per EUR since the common currency’s inception. There is a tolerance band of +/- 2.25%. The Danish central bank’s sole focus for monetary policy is “to keep the kroner stable against the euro”.

Maintenance of the peg

A EURDKK peg is in place to ensure low and stable prices. Denmark consistently runs at a trade surplus, meaning an artificially suppressed kroner favours Danish exporters. The abovementioned tolerance band is adhered to with frequent intervention in the foreign exchange markets through the buying/selling of DKK, as well as amending the country’s deposit rate. Currently, DNB holds FX reserves equating to USD$535billion – the second-highest figure on record.

Risks

In short, the chances of the EURDKK peg breaking are highly unlikely. Volatility for a 12-month at-the-money option has only peaked above DNB’s tolerance band three times in the peg’s history, with the last event instance occurring in 2015, during a spike in the Greek debt crisis. With the spike in uncertainty happening at a time of heightened geopolitical turmoil, it is conceivable that we see upside pressure on EURDKK volatility in the near term, given the current backdrop.