## How to Operationalize an Exchange Rate Peg

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---

### Purpose and scope
- Provides guidance for the operationalization of exchange rate peg arrangements to serve as a nominal anchor.
- Focuses on arrangements likely to perform well in ensuring long-run price stability: bilateral exchange rate pegs, pegs to a basket of currencies, crawling pegs, and bands.
- Intended audience: central bank practitioners and IMF country teams.
- Assumes authorities have already chosen an exchange rate regime and concluded that the exchange rate is the optimal nominal anchor.

### Fixed-parity exchange rate arrangements — key findings and guidance
- Objective: maintain the value of the currency in nominal terms, typically against a major reserve currency, alternatively a currency basket or a commodity such as gold.
- A peg functions as a nominal anchor by:
  - stabilizing tradable goods prices (important for small open economies),
  - anchoring inflation expectations,
  - requiring discipline in macroeconomic policies (monetary, fiscal, financial).
- Choice of anchor currency — desirable attributes:
  - A strong track record on inflation.
  - High convertibility (liquidly traded, low volatility).
  - Major invoicing currency (reduces exchange rate pass-through and transaction costs).
  - Strong financial linkages (mitigates balance sheet effects from FX-denominated debt).
  - Synchronization of business cycles.
- Empirical notes:
  - The US dollar plays a dominant role as an anchor currency.
  - AREAER (2024): 81 economies adopt an exchange rate anchor; among them, 38 peg to the US dollar and 25 peg to the euro.
- Basket pegs — benefits and operational challenges:
  - May stabilize the weighted-average exchange rate for economies with diversified international linkages.
  - Challenges: reduced simplicity and transparency, verification difficulty, limited shock absorption, higher institutional and operational capacity needs.
  - Empirical considerations and operational recommendations:
    - Each currency in the basket should satisfy anchor-currency attributes.
    - Composition and weights should be disclosed for transparency.
    - Number of currencies should be limited, typically not exceeding five.
    - Weight selection and adjustment process should support price stability.
    - Technical design choices (e.g., averaging method) are important.
  - AREAER: eight countries adopt a basket peg as their exchange rate anchor; additional countries use currency baskets under different frameworks.
- Commodity anchors:
  - Article IV, Section 2(b) prohibits maintaining value in terms of gold as of 1978.
  - Commodity pegs generally not advisable: commodity prices are typically more volatile than hard currencies and subject to nonfundamental shocks.
  - Commodity pegs can exacerbate Dutch disease, undermine diversification, and lower long-run growth.
  - Better policy tools for resource-rich countries: prudent countercyclical fiscal policy, sovereign wealth funds, and other macroeconomic tools.
- Institutional variant — currency boards:
  - Rules-based fixed arrangement with strict foreign reserve backing of base money.
  - Limits discretionary policy, often no active monetary policy instruments, limited lender-of-last-resort functions.
  - Requires strong fiscal discipline, adequate reserves, and a sound financial system.

### Crawling pegs — definition, benefits, and operationalization
- Definition: parity is periodically adjusted by a predetermined amount; "rate of crawl" is the speed of nominal exchange rate adjustment.
- Potential uses:
  - Allow the home country to target a different average inflation rate than the anchor.
  - Facilitate transition from high to lower inflation.
- Limitations:
  - Provides only limited shock absorption compared with floating rates.
  - Can be misused (e.g., to stabilize the real exchange rate) and jeopardize price stability.
- How to set the rate of crawl:
  - The rate of crawl should be consistent with price stability — chosen so domestic inflation runs near its desired level on average in the medium term or moves toward that level for high-inflation transitions.
  - Benchmark rate of crawl derives from steady-state considerations:
    - Balassa–Samuelson effects (trend change in relative price of nontradables vs tradables).
    - Desired average inflation rate difference with the anchor (πt − πt*).
  - Illustrative numeric example from equation (1):
    - If expected rise in relative price of nontraded goods is 3 percent per year and sN = 2/3, home inflation would exceed anchor inflation by 2 percent per year under a fixed peg; the home country could achieve parity by allowing the currency to appreciate by 2 percent (e(2). t∆=−).
  - For transition from high inflation:
    - An initial rate of crawl higher than the benchmark may be calibrated to ease disinflation costs and gradually converge to the benchmark.
    - Deviations from the benchmark should not be too large; changes to the benchmark should be infrequent (analogous to changing an inflation target).
  - Avoid real exchange rate pegs:
    - Real exchange rate peg sets rate of crawl equal to the inflation differential (e, t r∆ = πt − πt*), keeping ex-ante real exchange rate constant.
    - Not advisable: does not provide a nominal anchor, can cause price indeterminacy, higher inflation volatility, and welfare loss.
    - Historical example: Brazil’s experience linked to prolonged hyperinflation.
- Other operational parameters for crawling pegs:
  - Frequency of adjustment: reference rate should be adjusted daily; linear interpolation of an annual rate typically suffices.
  - Band: optional surrounding band; see bands section.
  - Review frequency of rate of crawl: regular but typically infrequent reviews; too frequent changes harm credibility.
  - Choice of variables: define precisely which measures of home and foreign inflation and exchange rates are used.
  - Contingency arrangements: allow out-of-cycle review under exceptional circumstances (e.g., large capital inflows).

### Bands — design, trade-offs, and typical bandwidths
- A band provides limited monetary policy autonomy and allows the exchange rate to act as a shock absorber.
- Benefits:
  - Limited intra-band flexibility; reduces need for FX intervention (FXI) against transitory shocks.
- Risks:
  - Too wide a band weakens the exchange rate's role as nominal anchor and may invite opportunistic use of the exchange rate for objectives other than price stability.
  - Wider bands combined with crawling arrangements or basket pegs compound loss of clarity and credibility.
- Design considerations:
  - Width should be narrow enough to preserve anchor credibility, but large enough to limit excessive FXI and operational costs.
  - No consensus on an optimal bandwidth; a low single-digit percentage is typical.
  - Historical and current examples:
    - ERM baseline allowed ±2.25 percent; Denmark pegs to the euro with a ±2.25 percent band under ERM II.
    - Many economies choose bandwidth between ±2 percent and ±5 percent.
    - Hong Kong SAR Convertibility Zone: HK$7.75–7.85 per US$ (about a ±0.6 percent bandwidth).
  - FXI modalities: standing facilities (rules-based) and discretionary FX operations; intramarginal smoothing interventions may be used.
  - Credibility elements: clear commitment, narrow band, and adequate reserves reinforce the peg within a band (honeymoon effect).

### Foreign exchange and monetary operations and other macroeconomic policies
- Core principle: domestic interest rates should track the equilibrium level consistent with the fixed or crawling exchange rate.
- Uncovered Interest Rate Parity (UIP) — fixed-parity case:
  - UIP condition: it = i*t + UIPt.
  - Definitions:
    - it: domestic nominal interest rate.
    - i*t: anchor currency nominal interest rate.
    - UIPt: UIP premium (risk premium).
  - Policy implications:
    - If central bank does not set policy rate, market forces drive rates to satisfy UIP via FXI and domestic liquidity adjustments.
    - If central bank sets policy rate, it must be consistent with UIP or persistent capital flows will arise.
- Determining appropriate foreign interest rate (i*t) and assessing UIP premium:
  - Choose the anchor-country interest rate that empirically influences capital flows most; consider forward-looking measures (e.g., interest rate swaps).
  - UIP premium typically positive for developing countries; it is time-varying and affected by sovereign/currency risk.
  - Proxies and estimation aids:
    - Professional forecasts of future exchange rates.
    - Eurobond yield spreads or sovereign CDS.
    - Deviations from covered interest parity (CIP) using FX derivative markets.
    - Market liquidity and depth measures (trade volumes, bid-ask spreads, Amihud illiquidity).
    - Other macro variables (GDP growth, commodity prices).
  - Real-time estimation is challenging; expert judgment should complement models and reference formulas.
- Responding to UIP shocks:
  - If UIP premium increases (capital outflow pressure), central bank may raise policy rate by the shock amount or use FX sales to stem outflows — trade-off between policy rate adjustments and FXI.
  - Temporary deviations from UIP may be justified for transitory shocks to avoid excessive interest rate volatility, but deviations should remain temporary.
  - Relying on FXI is more feasible when capital flows are less sensitive to interest rate differentials; otherwise policy rate adjustments are necessary.
  - Costs of deviating from UIP depend on international reserve levels: insufficient reserves make low rates dangerous; excessive reserve accumulation via high rates is quasi-fiscal costly.
- UIP condition generalized for moving exchange rates:
  - it = i*t + E[e_{t+1} − e_t] + UIPt.
  - For crawling pegs: domestic interest rate should compensate for expected depreciation equal to the rate of crawl.
  - For basket pegs: i*t should be the weighted average of basket currencies’ interest rates using the basket weights.
  - For bands: interest rates should respond proactively and symmetrically to deviations within the band (asymmetric responses may be justified if reserves are low).
- Monetary and FX operations:
  - FX operations typically conducted through standing facilities at the official rate in unlimited amounts for authorized transactions.
  - Intramarginal FXI at market rates is generally limited to arrangements with wider bands.
  - Central banks may conduct domestic liquidity operations to reduce short-term interest rate volatility even if not steering the policy rate.
  - Implementation complexity: OMOs are more complex under fixed pegs without capital controls because FXI volume is not controlled by central bank; liquidity forecasting is challenging.
  - Mitigants:
    - Frequent OMOs and longer reserve requirement maintenance periods.
    - Clearly defined interest rate corridors.
    - Reserve requirement averaging to smooth temporary liquidity imbalances.
    - High-frequency operations (daily OMOs) to absorb excess liquidity.
- Coordination with other macroeconomic policies:
  - Fiscal policy: should be countercyclical and prudent to compensate for loss of monetary autonomy.
  - Structural policies: enhance productivity and competitiveness to mitigate long-run competitiveness loss under pegs.
  - Financial sector policy: strong supervision and macroprudential frameworks to monitor credit, external debt, and currency mismatch.
  - Capital flow management measures (CFMs) and CFM/MPMs: may be useful; IMF Institutional View provides policy advice.
- Communications and transparency:
  - Central bank must clearly state that the objective of fixed or crawling exchange rate arrangements is to provide a nominal anchor for price stability; if secondary objectives exist, price stability should be prioritized.
  - Forward-looking communication aids expectation formation and policy predictability.
  - Operational details should be publicly available to strengthen credibility: currency basket composition and weights, reference rate or rate of crawl, band width, rules for FX operations and standing facilities.
  - Alignment of de facto and de jure arrangements and legal enshrinement can enhance credibility.
  - Strengthening monetary policy transmission and best practices in communication support the operation and resilience of peg arrangements.

### Annex 1. Considerations for the Technical Design of a Basket Peg
- The averaging method:
  - Use a geometric average when calculating the currency basket rate as a weighted average of bilateral exchange rates, to ensure that basket weights remain stable over time.
  - Arithmetic averaging is not recommended as it can cause weights to drift as bilateral exchange rates fluctuate.
- Intervention currency:
  - Monetary authorities should designate an intervention currency for FX interventions to maintain the basket rate.
  - Desirable properties: highly liquid, widely traded, suitable as a reserve asset, and relevant to the currency basket.
  - It is natural to designate one of the constituent currencies of the basket; in practice, countries often designate the US dollars as the intervention currency.
- Frequency of the updates in the basket rate:
  - The basket rate should be updated frequently, at least several times a day, to reflect developments in the bilateral exchange rates in the basket.
  - Frequent updates avoid deviation of the basket exchange rate from the basket-weighted bilateral exchange rates and the possibility of arbitrage if capital flows are free.
  - The more currencies included in the basket, the more cumbersome the adjustment and the greater the risk of large deviations.
- Frequency of the review of the basket:
  - Balance maintaining a stable basket for credibility with reflecting structural changes in international linkages.
  - Too frequent changes harm credibility; too few changes make the basket less relevant.
  - Practical recommendation: review the basket weights at a regular frequency (say every five years), not tied to cyclical conditions.
  - Weights should be adjusted to reflect the latest data; ensuring data accuracy and reliability supports informed decision making.
- Approaches to calibrating currency weights:
  - Traditional practice: use trade weights as currency weights in a basket.
  - Shortcomings: trade weights may induce high variability in import price inflation if invoicing currency differs from trade composition; imports tend to be heavily invoiced in US dollars in practice.
  - Alternative approach: choose basket weights to minimize variability of imported price inflation, taking account of heterogeneity in pass-through and co-movement of currencies (treating weights as a portfolio choice problem).

*Source: htnea2026006 — How to Operationalize an Exchange Rate Peg*

### Introduction

### htnea2026006 - Introduction

### Main sections and page references
- Introduction — 3
- Fixed-Parity Exchange Rate Arrangements — 4
- Crawling Pegs — 10
- Bands — 15
- Foreign Exchange and Monetary Operations and Other Macroeconomic Policies — 17

### Annexes (with page references)
- Annex 1. Considerations for the Technical Design of a Basket Peg — 25
- Annex 2. Brief Overview of Currently Existing Crawling Arrangements — 27
- Annex 3. Examples of Fixed Exchange Rate Arrangements — 28
- Annex 4. Use of Capital Flow Management Measures under Exchange Rate Pegs — 32
- References — 33

### Figures (with figure identifiers and page references)
- Figure A3.1. Interbank Rates in Hong Kong SAR — 29
- Figure A3.2. Hong Kong Dollar Dynamics and Interbank Interest Rate Differentials in Hong Kong SAR — 29
- Figure A3.3. Policy Rates and Interbank Rates in Saudi Arabia — 30
- Figure A3.4. Policy Rates in the Euro Area and Denmark — 31

### Abbreviations listed on the page
- AREAER Annual Report on Exchange Arrangements and Exchange Restrictions
- CFMs capital flow management measures
- CIP covered interest rate parity
- DN Danmarks Nationalbank
- ECB European Central Bank
- ERM European Exchange Rate Mechanism
- FX foreign exchange
- FXI foreign exchange intervention
- HK$ Hong Kong dollar
- HKMA Hong Kong Monetary Authority
- MPMs macroprudential measures
- OMOs open market operations
- UIP uncovered interest rate parity

### Document notes
- The document includes placeholder pages marked "This page intentionally left blank" at least twice.
- The content unit title on the document is "How to Operationalize an Exchange Rate Peg".

*Source: htnea2026006 - Introduction*

### Introduction

### Introduction

### Purpose and scope
- Provides guidance for the operationalization of exchange rate peg arrangements to serve as a nominal anchor.
- Focuses on arrangements likely to perform well in ensuring long-run price stability: bilateral exchange rate pegs, pegs to a basket of currencies, crawling pegs, and bands.
- Intended audience: central bank practitioners and IMF country teams.
- Assumes authorities have already chosen an exchange rate regime and concluded that the exchange rate is the optimal nominal anchor.

### Fixed-parity exchange rate arrangements — key findings and guidance
- Objective: maintain the value of the currency in nominal terms, typically against a major reserve currency, alternatively a currency basket or a commodity such as gold.
- A peg functions as a nominal anchor by:
  - stabilizing tradable goods prices (important for small open economies),
  - anchoring inflation expectations,
  - requiring discipline in macroeconomic policies (monetary, fiscal, financial).
- Choice of anchor currency — desirable attributes:
  - A strong track record on inflation.
  - High convertibility (liquidly traded, low volatility).
  - Major invoicing currency (reduces exchange rate pass-through and transaction costs).
  - Strong financial linkages (mitigates balance sheet effects from FX-denominated debt).
  - Synchronization of business cycles.
- Empirical notes:
  - The US dollar plays a dominant role as an anchor currency.
  - AREAER (2024): 81 economies adopt an exchange rate anchor; among them, 38 peg to the US dollar and 25 peg to the euro.
  - Some countries peg to large neighbors (examples cited in source).
- Basket pegs — benefits and operational challenges:
  - May stabilize the weighted-average exchange rate for economies with diversified international linkages.
  - Challenges: reduced simplicity and transparency, verification difficulty, limited shock absorption, higher institutional and operational capacity needs.
  - Empirical considerations and operational recommendations:
    - Each currency in the basket should satisfy anchor-currency attributes.
    - Composition and weights should be disclosed for transparency.
    - Number of currencies should be limited, typically not exceeding five.
    - Weight selection and adjustment process should support price stability.
    - Technical design choices (e.g., averaging method) are important.
  - AREAER: eight countries adopt a basket peg as their exchange rate anchor; additional countries use currency baskets under different frameworks.
- Commodity anchors:
  - Historically used (gold standard, Bretton Woods) but Article IV, Section 2(b) prohibits maintaining value in terms of gold as of 1978.
  - Commodity pegs generally not advisable: commodity prices are typically more volatile than hard currencies and subject to nonfundamental shocks.
  - Commodity pegs can exacerbate Dutch disease, undermine diversification, and lower long-run growth.
  - Better policy tools for resource-rich countries: prudent countercyclical fiscal policy, sovereign wealth funds, and other macroeconomic tools.
- Institutional variant — currency boards:
  - Rules-based fixed arrangement with strict foreign reserve backing of base money.
  - Limits discretionary policy, often no active monetary policy instruments, limited lender-of-last-resort functions.
  - Requires strong fiscal discipline, adequate reserves, and a sound financial system.

### Crawling pegs — definition, benefits, and operationalization
- Definition: parity is periodically adjusted by a predetermined amount; "rate of crawl" is the speed of nominal exchange rate adjustment.
- Potential uses:
  - Allow the home country to target a different average inflation rate than the anchor.
  - Facilitate transition from high to lower inflation.
- Limitations:
  - Provides only limited shock absorption compared with floating rates.
  - Can be misused (e.g., to stabilize the real exchange rate) and jeopardize price stability.
- How to set the rate of crawl:
  - The rate of crawl should be consistent with price stability — chosen so domestic inflation runs near its desired level on average in the medium term or moves toward that level for high-inflation transitions.
  - Benchmark rate of crawl derives from steady-state considerations:
    - Balassa–Samuelson effects (trend change in relative price of nontradables vs tradables).
    - Desired average inflation rate difference with the anchor (
tt
*
ππ−
).
  - Illustrative numeric example from equation (1):
    - If expected rise in relative price of nontraded goods is 3 percent per year and sN = 2/3, home inflation would exceed anchor inflation by 2 percent per year under a fixed peg; the home country could achieve parity by allowing the currency to appreciate by 2 percent (e(2). t∆=−).
  - For transition from high inflation:
    - An initial rate of crawl higher than the benchmark may be calibrated to ease disinflation costs and gradually converge to the benchmark.
    - Deviations from the benchmark should not be too large; changes to the benchmark should be infrequent (analogous to changing an inflation target).
  - Avoid real exchange rate pegs (see below).
- Real exchange rate peg — not advisable:
  - Rule sets rate of crawl equal to the inflation differential (e, t r∆ = πt − πt*), keeping ex-ante real exchange rate constant.
  - Theoretical and empirical literature: real exchange rate peg does not provide a nominal anchor, can cause price indeterminacy, higher inflation volatility, and welfare loss.
  - Historical example: Brazil’s experience linked to prolonged hyperinflation.
- Other operational parameters for crawling pegs:
  - Frequency of adjustment: reference rate should be adjusted daily; linear interpolation of an annual rate typically suffices.
  - Band: optional surrounding band; see bands section.
  - Review frequency of rate of crawl: regular but typically infrequent reviews; too frequent changes harm credibility.
  - Choice of variables: define precisely which measures of home and foreign inflation and exchange rates are used.
  - Contingency arrangements: allow out-of-cycle review under exceptional circumstances (e.g., large capital inflows).

### Bands — design, trade-offs, and typical bandwidths
- A band provides limited monetary policy autonomy and allows the exchange rate to act as a shock absorber.
- Benefits:
  - Limited intra-band flexibility; reduces need for FX intervention (FXI) against transitory shocks.
- Risks:
  - Too wide a band weakens the exchange rate's role as nominal anchor and may invite opportunistic use of the exchange rate for objectives other than price stability.
  - Wider bands combined with crawling arrangements or basket pegs compound loss of clarity and credibility.
- Design considerations:
  - Width should be narrow enough to preserve anchor credibility, but large enough to limit excessive FXI and operational costs.
  - No consensus on an optimal bandwidth; a low single-digit percentage is typical.
  - Historical and current examples:
    - ERM baseline allowed ±2.25 percent; Denmark pegs to the euro with a ±2.25 percent band under ERM II.
    - Many economies choose bandwidth between ±2 percent and ±5 percent.
    - Hong Kong SAR Convertibility Zone: HK$7.75–7.85 per US$ (about a ±0.6 percent bandwidth).
  - FXI modalities: standing facilities (rules-based) and discretionary FX operations; intramarginal smoothing interventions may be used.
  - Credibility elements: clear commitment, narrow band, and adequate reserves reinforce the peg within a band (honeymoon effect).

### Foreign exchange and monetary operations; coordination with other macroeconomic policies
- Core principle: domestic interest rates should track the equilibrium level consistent with the fixed or crawling exchange rate.
- Uncovered Interest Rate Parity (UIP) — fixed-parity case:
  - UIP condition: it = i*t + UIPt.
  - it: domestic nominal interest rate; i*t: anchor currency nominal interest rate; UIPt: UIP premium (risk premium).
  - If central bank does not set policy rate, market forces drive rates to satisfy UIP via FXI and domestic liquidity adjustments.
  - If central bank sets policy rate, it must be consistent with UIP or persistent capital flows will arise.
- Determining the appropriate foreign interest rate (i*t) and assessing UIP premium:
  - Choose the anchor-country interest rate that empirically influences capital flows most; consider forward-looking measures (e.g., interest rate swaps).
  - UIP premium typically positive for developing countries; it is time-varying and affected by sovereign/currency risk.
  - Proxies and estimation aids:
    - Professional forecasts of future exchange rates.
    - Eurobond yield spreads or sovereign CDS.
    - Deviations from covered interest parity (CIP) using FX derivative markets.
    - Market liquidity and depth measures (trade volumes, bid-ask spreads, Amihud illiquidity).
    - Other macro variables (GDP growth, commodity prices).
  - Real-time estimation is challenging; expert judgment should complement models and reference formulas.
- Responding to UIP shocks:
  - If UIP premium increases (capital outflow pressure), central bank may raise policy rate by the shock amount or use FX sales to stem outflows — trade-off between policy rate adjustments and FXI.
  - Temporary deviations from UIP may be justified for transitory shocks to avoid excessive interest rate volatility, but deviations should remain temporary.
  - Relying on FXI is more feasible when capital flows are less sensitive to interest rate differentials; otherwise policy rate adjustments are necessary.
  - Costs of deviating from UIP depend on international reserve levels: insufficient reserves make low rates dangerous; excessive reserve accumulation via high rates is quasi-fiscal costly.
- UIP condition generalized for moving exchange rates:
  - it = i*t + E[e_{t+1} − e_t] + UIPt.
  - For crawling pegs: domestic interest rate should compensate for expected depreciation equal to the rate of crawl.
  - For basket pegs: i*t should be the weighted average of basket currencies’ interest rates using the basket weights.
  - For bands: interest rates should respond proactively and symmetrically to deviations within the band (asymmetric responses may be justified if reserves are low).
- Monetary and FX operations:
  - FX operations typically conducted through standing facilities at the official rate in unlimited amounts for authorized transactions.
  - Intramarginal FXI at market rates is generally limited to arrangements with wider bands.
  - Central banks may conduct domestic liquidity operations to reduce short-term interest rate volatility even if not steering the policy rate.
  - Implementation complexity: OMOs are more complex under fixed pegs without capital controls because FXI volume is not controlled by central bank; liquidity forecasting is challenging.
  - Mitigants:
    - Frequent OMOs and longer reserve requirement maintenance periods.
    - Clearly defined interest rate corridors.
    - Reserve requirement averaging to smooth temporary liquidity imbalances.
    - High-frequency operations (daily OMOs) to absorb excess liquidity.
- Coordination with other macroeconomic policies:
  - Fiscal policy: should be countercyclical and prudent to compensate for loss of monetary autonomy.
  - Structural policies: enhance productivity and competitiveness to mitigate long-run competitiveness loss under pegs.
  - Financial sector policy: strong supervision and macroprudential frameworks to monitor credit, external debt, and currency mismatch.
  - Capital flow management measures (CFMs) and CFM/MPMs: may be useful; IMF Institutional View provides policy advice.
- Communications and transparency:
  - Central bank must clearly state that the objective of fixed or crawling exchange rate arrangements is to provide a nominal anchor for price stability; if secondary objectives exist, price stability should be prioritized.
  - Forward-looking communication aids expectation formation and policy predictability.
  - Operational details should be publicly available to strengthen credibility: currency basket composition and weights, reference rate or rate of crawl, band width, rules for FX operations and standing facilities.
  - Alignment of de facto and de jure arrangements and legal enshrinement can enhance credibility.
  - Strengthening monetary policy transmission and best practices in communication support the operation and resilience of peg arrangements.

*Source: htnea2026006 - Introduction*

### Annex 1. Considerations for the

### Annex 1. Considerations for the Technical Design of a Basket Peg

### The averaging method
- When calculating the currency basket rate as a weighted average of bilateral exchange rates, a geometric average should be used to ensure that basket weights remain stable over time.
- An arithmetic averaging is not recommended as it can cause weights to drift as bilateral exchange rate fluctuates.

### Intervention currency
- The monetary authorities should designate the intervention currency, which is a currency used for interventions in the foreign exchange market, particularly when actions are required to maintain the basket rate.
- Desirable properties of the intervention currency:
  - Highly liquid
  - Widely traded
  - Suitable as a reserve asset
  - Relevant to the currency basket (that is, carrying a significant weight in the basket)
- It is natural to designate one of the constituent currencies of the basket for this purpose.
- In practice, countries that currently operate a basket peg regime often designate the US dollars as the intervention currency, reflecting its dominant role in international trade and finance, as well as its high liquidity and prevalence in official reserves.

### Frequency of the updates in the basket rate
- The basket rate should be updated frequently, at least several times a day, to reflect developments in the exchange rates of the bilateral exchange rates in the basket.
- The update should occur at a certain time during the day.
- Rationale:
  - Frequent updates avoid deviation of the basket exchange rate from the basket-weighted bilateral exchange rates and the possibility of arbitrage if capital flows are free.
  - The more currencies included in the basket, the more cumbersome it would be to implement this adjustment and the more likely the risk of large deviations.

### Frequency of the review of the basket
- The frequency of the review should strike a balance between maintaining a stable basket to enhance the credibility of the basket peg as a nominal anchor and reflecting structural changes in the economy’s international linkages into the basket composition.
- Risks:
  - Too frequent changes in the basket composition may be harmful for the credibility of the peg.
  - Too few changes could make the basket less relevant to the structure of the home economy.
- Practical recommendation:
  - Review the basket weights at a regular frequency (say every five years), but that is not tied to cyclical conditions.
  - Regular reviews help avoid the perception that the weights are being changed for opportunistic reasons.
- The weights should be adjusted to reflect the latest data.
- Ensuring the accuracy and reliability of the data will facilitate informed decision making on the composition and management of the currency basket.
- Regular reviews are also beneficial for strengthening the central bank’s capacity to implement its exchange rate policy framework effectively and manage the currency basket.

### Approaches to calibrating currency weights
- Traditional practice:
  - Countries adopting a basket peg have traditionally used trade weights as currency weights in a basket.
- Shortcomings of trade-weighted approach:
  - It may induce high variability in import price inflation if the currency composition of invoicing differs substantially from that of overall trade.
  - In practice, imports tend to be heavily invoiced in US dollars, even for countries with relatively low bilateral trade ties to the United States.
- Alternative approach:
  - A forthcoming IMF working paper (Vaccaro-Grange, forthcoming) shows how a country may choose basket weights to minimize the variability of imported price inflation in a way that takes account of heterogeneity in pass-through from basket currencies and also their co-movement (treating the choice of weights as a portfolio choice problem).
  - Such an approach may come close to stabilizing the variability in the overall inflation for highly open economies in which imports are a large share of the consumption bundle, and perform much better on this key dimension than the traditional approach of using trade weights.

*Source: Annex 1. Considerations for the Technical Design of a Basket Peg*

### References

### References

### Bibliographic entries

- Adams, Charles, and Daniel Gros. 1986. “The Consequences of Real Exchange Rate Rules for Inflation: Some Illustrative Examples.” IMF Economic Review 33: 439–76.
- Ahn, JaeBin, Rui Mano, and Jing Zhou. 2020. “Real Exchange Rate and External Balance: How Important Are Price Deflators?” Journal of Money, Credit and Banking  5 2 :   2111– 3 0 .
- Alesina, Alberto F., Robert J. Barro, and Silvana Tenreyro. 2002. “Optimal Currency Areas.” NBER Macroeconomics Annual  17:   3 01– 4 5 .
- Allen, Cian, Camila Casas, Giovanni Ganelli, Luciana Juvenal, Daniel Leigh, Pau Rabanal, Cyril Rebillard, Jair Rodriguez, and João Tovar Jalles. 2023. “2022 Update of the External Balance Assessment Methodology.” IMF Working Paper No. 23/47, International Monetary Fund, Washington, D.C.
- Amihud, Yakov. 2002. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects.” Journal of Financial Markets 5: 31–56.
- Ayres, Joao, Marcio Garcia, Diogo A. Guillen, and Patrick J. Kehoe. 2019. “The Monetary and Fiscal History of Brazil, 1960-2016.” NBER Working Paper, No. 25421, National Bureau of Economic Research, Cambridge, MA.
- Banque de France. 2022. “The Remarkable Resilience of Hong Kong’s Exchange Rate Regime.” Bulletin de la Banque de France, 239/4.
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*How to Operationalize an Exchange Rate Peg — References*

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_Source: https://www.imf.org/-/media/files/publications/howtonotes/2026/english/htnea2026006.pdf_