A dollar peg occurs when a country’s currency maintains a fixed exchange rate with the US dollar. The central bank of the country keeps track of the value of its currency, which rises and falls in tandem with the dollar. Because the dollar is based on a floating exchange rate, its value fluctuates.
At least 66 countries have their currencies pegged to the dollar or use it as legal tender. Because it is the world’s reserve currency, the dollar is extremely popular. At the 1944 Bretton Woods Agreement, world leaders granted it that status.
The euro is the runner-up. It is linked to the currencies of twenty-five countries. It is the currency of the Eurozone’s 19 members.
What Is a Currency Peg?
A currency peg is a policy in which a country’s government establishes a fixed exchange rate for its currency against a foreign currency or a basket of currencies. The exchange rate between countries is stabilized by pegging a currency. This ensures long-term exchange rate predictability for business planning. A currency peg, on the other hand, can be difficult to maintain and distort markets if it is too far from the natural market price.
How Does a Currency Peg Work?
Currency pegs are primarily used to encourage cross-border trade by lowering foreign exchange risk. Because many businesses have thin profit margins, even a small change in exchange rates can wipe out profits and force businesses to seek new suppliers. This is especially true in the fiercely competitive retail sector.
A currency peg is usually established with a stronger or more developed economy so that domestic companies can access broader markets with less risk. The US dollar, the euro, and gold have all been popular choices in the past. Currency pegs provide trading partners with stability and can last for decades. The Hong Kong dollar, for example, has been pegged to the US dollar since 1983.
Advantages of Pegged Exchange Rates
Pegged currencies can help boost trade and real incomes, especially when currency fluctuations are low and there are no long-term changes. Individuals, businesses, and nations are free to benefit fully from specialization and exchange without exchange rate risk or tariffs. Everyone will be able to spend more time doing what they do best, according to the theory of comparative advantage.
Farmers will be able to focus on producing food as best they can instead of wasting time and money hedging foreign exchange risk with derivatives, thanks to pegged exchange rates. Similarly, technology companies will be able to concentrate their efforts on developing better computers.
Most importantly, both countries’ retailers will be able to source from the most efficient producers. Exchange rates that are pegged allow for more long-term investments in the other country. With a currency peg, fluctuating exchange rates do not disrupt supply chains or change the value of investments as frequently.
Disadvantages of Pegged Currencies
To avoid spikes in demand or supply, the central bank of a country with a currency peg must monitor supply and demand and manage cash flow. These spikes can cause a currency’s pegged price to deviate. To counteract excessive buying or selling of its currency, the central bank will need to hold large foreign exchange reserves. Currency pegs have an impact on forex trading because they artificially reduce volatility.
When a currency is pegged at an excessively low exchange rate, countries face a unique set of issues. On the one hand, domestic consumers will be unable to purchase foreign goods due to a lack of purchasing power. Assume the Chinese yuan is overvalued in relation to the US dollar.
Consumers in China will then have to pay more for imported food and oil, lowering their consumption and living standards. Farmers in the United States and Middle Eastern oil producers, on the other hand, who would have sold them more goods, lose business. Trade tensions naturally arise between the country with the undervalued currency and the rest of the world as a result of this situation.
When a currency is pegged at an excessively high rate, a new set of issues arise. Over time, a country may be unable to defend the peg. Domestic consumers will buy too many imports and consume more than they can produce because the government sets the rate too high.
The government will have to spend foreign exchange reserves to defend the peg as a result of these chronic trade deficits, which will put downward pressure on the domestic currency. The government’s reserves will be depleted at some point, and the peg will fall apart.
When a currency peg collapses, imports become more expensive for the country that set the peg too high. As a result, inflation will rise, and the country may face difficulties repaying its debts. The exporters of the other country will lose markets, and investors will lose money on foreign assets that are no longer worth as much in local currency.
The Argentine peso to the US dollar in 2002, the British pound to the German mark in 1992, and, arguably, the US dollar to gold in 1971 are all examples of major currency peg breakdowns.
Why Countries Peg Their Currency to the Dollar
Many countries want to peg their currencies to the US dollar because it is the world’s reserve currency. The fact that most financial transactions and international trade are conducted in US dollars is one of the reasons. Countries that rely heavily on their financial sector float their currencies against the dollar. Hong Kong, Malaysia, and Singapore are examples of trade-dependent countries.
Other countries that export a lot to the US peg their currencies to the dollar in order to keep their prices competitive. They try to keep their currency’s value lower than the dollar’s. Because of the lower currency value, they have a competitive advantage in terms of exporting to America.
The yen is not exactly pegged to the dollar in Japan. It takes a similar approach to China. Because it exports so much to the United States, it tries to keep the yen low against the dollar. It receives a large sum of money in return, similar to China. As a result, Japan’s central bank is the largest buyer of US Treasury bonds.
Because oil is sold in dollars, other countries, such as those in the Gulf Cooperation Council that export oil, must peg their currencies to the dollar. As a result, their sovereign wealth funds contain large sums of money. To earn a higher return, these petrodollars are frequently invested in U.S. businesses. For example, Abu Dhabi put money into Citigroup to keep it from going bankrupt in 2008.
Countries that do a lot of business with China will have their currencies pegged to the dollar as well. They want to compete in the Chinese market with their exports. They want their export prices to be pegged to the Chinese yuan at all times. This is accomplished by pegging their currency to the US dollar.