What Is a Currency Peg?
A currency peg is a policy in which a national government or central bank sets a fixed exchange rate for its currency with a foreign currency or a basket of currencies and stabilizes the exchange rate between countries.
The currency exchange rate is the value of a currency compared to another. While some currencies are free-floating and rates fluctuate based on supply and demand in the market, others are fixed and pegged to another currency.
Pegging provides long-term predictability of exchange rates for business planning and helps to promote economic stability.
Key Takeaways
- A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a foreign currency or basket of currencies.
- A currency peg can reduce uncertainty, promote trade, and boost economies.
- An overly low currency peg keeps domestic living standards low, hurts foreign businesses, and creates trade tensions among countries.
- An artificially high currency peg contributes to the overconsumption of imports and often causes inflation when it collapses.
- As of 2022, 14 countries peg their currencies to the U.S. dollar.
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Understanding Currency Pegging
The primary motivation for a currency peg is to encourage trade between countries by reducing foreign exchange risk. Countries commonly establish a currency peg with a stronger or more developed economy so that domestic companies can access broader markets with less risk.
The U.S. dollar, the euro, and gold have historically been popular choices. Currency pegs create stability between trading partners and can remain in place for decades. For example, the Hong Kong dollar has been pegged to the U.S. dollar since 1983.
Only realistic currency pegs aimed at reducing volatility can produce economic benefits. Setting a currency peg artificially high or low creates imbalances that ultimately harm all countries involved.
Advantages of a Currency Peg
Pegged currencies can expand trade and boost real incomes, particularly when currency fluctuations are relatively low and foresee no long-term changes. Without exchange rate risk and tariffs, individuals, businesses, and nations are free to benefit fully from specialization and exchange.
With fixed exchange rates and within a mutually beneficial economic framework, farmers may be able to effectively produce, technology firms may be able to expand research and development, and retailers will be able to source from efficient producers.
Pegging allows for long-term investments in other countries as fluctuating exchange rates are not disrupting supply chains and altering the value of investments.
Disadvantages of a Currency Peg
The central bank of a country with a currency peg must monitor and manage cash flow and avoid spikes in a currency's supply and demand. These spikes can require a central bank to hold large foreign exchange reserves to counter excessive buying or selling of its currency. Currency pegs affect forex trading by artificially stemming volatility.
When a currency is pegged at an excessively low exchange rate, domestic consumers will be deprived of the purchasing power to buy foreign goods. If the Chinese yuan is pegged too low against the U.S. dollar, Chinese consumers will have to pay more for imported food and oil, lowering their consumption and affecting their standard of living. The sellers, U.S. farmers, and Middle East oil producers, see a decrease in demand, and business loss and trade tensions may escalate among the countries.
If a currency is pegged at an overly high rate, a country may be unable to defend the peg over time. Domestic consumers may buy too many imports and drive up demand. Chronic trade deficits create downward pressure on the home currency, forcing the government to spend foreign exchange reserves to defend the peg. If government reserves are exhausted, the peg will collapse.
As a currency peg collapses, the country that set the peg high will find imports more expensive. Inflation will rise, and the nation may have difficulty paying its debts. The other country will find its exporters losing markets, and its investors losing money on foreign assets that are no longer worth as much in domestic currency. Major currency peg breakdowns include the Argentine peso to the U.S. dollar in 2002, the British pound to the German mark in 1992, and arguably the U.S. dollar to gold in 1971.
Pros
Expands trade and boosts real incomes
Makes long-term investments realistic
Reduces disruptions to supply chains
Minimizes changes to the value of investments
Cons
Affects forex trading by artificially stemming volatility
Erodes purchasing power when pegged too low
Creates trade deficits when pegged too high
Increases inflation when pegged too high
Example of a Currency Peg
Since 1986, the Saudi riyal has been pegged at a fixed rate of 3.75 to the USD. The Arab oil embargo of 1973, Saudi Arabia's response to the United State's involvement in the Arab-Israeli war, precipitated events that led to the currency peg.
The effects of the short-lived embargo devalued the U.S. Dollar and led to economic turmoil. The Nixon administration drafted a deal with the Saudi government to restore the USD to the super currency it once was. From this arrangement, the Saudi government enjoyed the use of U.S. military resources, an abundance of U.S. Treasury savings, and a booming economy saturated with the USD.
During the embargo, the riyal was supported by Special Drawing Rights (SDR), an international reserve asset created by the International Monetary Fund to supplement the official reserves of its member countries with freely usable currencies of IMF members to provide a country with liquidity.
Due to high inflation and the 1979 Energy Crisis, the riyal suffered a devaluation, leading the Saudi government to peg the riyal to the US Dollar. The currency peg restored stability and lowered inflation. The Saudi Arabian Monetary Authority (SAMA) credits the peg for supporting economic growth in its country and for stabilizing the cost of foreign trade.
Why Would a Country Peg Their Currency?
The most common reasons include encouraging trade between nations, reducing the risks associated with expanding into broader markets and stabilizing the economy.
Which Countries Have Currencies That Are Pegged to the USD?
Fourteen countries have currencies pegged to the USD and include Bahrain, Belize, Cuba, Djibouti, Hong Kong SAR, China, Jordan, Lebanon, Oman, Panama, Qatar, Saudi Arabia, United Arab Emirates, and Eritrea.
How Many Currencies Are Pegged to the Euro?
Eleven currencies are pegged to the Euro (EUR), including the Croatian kuna and the Moroccan dirham.
What Is a Soft Peg?
A soft peg is an exchange rate policy where a government allows the exchange rate to be set by the market, but in some cases, especially if the exchange rate appears to move rapidly in one direction, the central bank will intervene in the market.
The Bottom Line
A currency peg is a nation's governmental policy whereby its exchange rate with another country is fixed. Most nations peg their currencies to promote trade and foreign investment and encourage stability.
