Today’s economic reality includes a world of free-floating fiat currencies, where the value of a nation’s currency is determined by supply and demand in the global foreign exchange or forex market. That has not always been the case, however, since relatively fixed exchange rate systems like the Bretton Woods system dominated most of the 20th century after World War II concluded.
Because fiat currencies generally lack backing other than the faith and credit of the issuing government, some national central banks or monetary authorities feel the need for a mechanism outside of the forces of supply and demand to control the value of their currency.
Maintaining a fixed exchange rate or currency peg can be a solution for a government to gain some level of control over the relative value of its national currency in the forex market. A currency peg will typically involve periodic interventions by a central bank to buy or sell their national currency in the forex market.
Read on to find out more about currency pegs and how they might affect your forex trading.
What is a Currency Peg?
Also known as a fixed exchange rate, currency pegging consists of the public policy of a national government, monetary authority or central bank to fix the value of its currency to another asset. The asset a national currency is pegged to can be a hard currency, such as gold or silver, or it can be another fiat currency, such as the U.S. dollar.
In practice, implementing a currency peg usually requires that the exchange rate of the pegging currency — meaning the currency that is being pegged to another currency called the peg currency — must be actively managed by a central bank or monetary authority. That authority usually uses its reserves to buy or sell the pegging currency against the peg currency in the forex market.
Small or developing countries often establish a currency peg with the currency of a country that has a stronger and more evolved economy. This practice helps domestic companies participate in more international markets while taking considerably less exchange rate risk than normal.
How Does Currency Pegging Work?
In practice, a monetary authority aiming to peg its currency might select a specific exchange rate versus another currency to peg its currency to. A variation on that type of peg would be to instead specify a range of permitted exchange rates for the country’s currency relative to another currency or basket of currencies.
The monetary authority will announce the fixed exchange rate policy to the public. It will then defend the specified pegged rate or range of rates by making transactions in the open forex market.
Some countries, most notably China in recent years, have managed to maintain a pegged exchange rate by using strict capital controls and making it against the law to transact their currency at any rate but the pegged rate.
While this sort of currency policy can be hard to enforce in practice and can even result in black market transactions, countries like China that maintain strong government controls over money conversion transactions have used this method quite successfully.
Example of Currency Pegging
The Chinese renminbi, which has the yuan as its base unit, has been pegged on and off against the U.S. dollar for most of its history. By pegging its currency to the U.S. dollar periodically, the Chinese government generally aimed to keep the value of its currency low.
As an example of the management of this currency by the Peoples Bank of China (PBOC), the renminbi peg was maintained from 1997 to 2005 at an exchange rate of 8.3 versus the U.S. dollar. In July 2005, the PBOC bowed to heavy pressure from the U.S. government and announced that it would lift the peg and phase in a more flexible exchange rate system so that the renminbi could strengthen somewhat.
Despite that public policy shift to a more flexible exchange rate, the renminbi has only fluctuated in a rather tight range between 6.04 and 7.18 per dollar from 2012 to the present day as the chart below shows.
Keeping the renminbi at an artificially maintained depreciated peg value had the effect of making Chinese exports cost less to foreigners. Chinese products thus became more competitive compared to products made in other countries, which helped the Chinese sell more of their goods and services in international markets.
As an example of just how successful this currency peg policy was in promoting Chinese-made goods, an estimated 70% to 80% of the products sold by big-box U.S. retailer Walmart were made in China. U.S. officials eventually pushed for a rise in the value of the renminbi for years to reduce the large trade deficit the U.S. was routinely running with China.
In response and to help keep a lid on inflation in China, the Chinese leadership has been allowing the value of the renminbi to rise in more recent years under a floating exchange rate policy based on market forces and managed relative to a basket of currencies.
China’s exports became less competitive in world markets, however, once the renminbi was allowed to float more freely against the dollar and other world currencies.
Advantages of a Currency Peg
Currency pegs come with their own set of risks and rewards. Here are the advantages traders need to know about.
Reduced Volatility and Risk
The main effect of a currency peg policy for a country is to reduce the volatility in the pegged currency versus one or more of the country’s key trading partners. This practice helps reduce the foreign exchange risk run by domestic businesses involved in international trade.
As a result of the reduced forex market volatility and risk, a currency peg can help reduce uncertainty, promote foreign trade and boost the economy of a country implementing it.
As a historical example, the Chinese economy greatly benefitted from its currency peg policy. Pegging the Chinese renminbi to the U.S. dollar also resulted in a value for the renminbi that was substantially below its purchasing power parity level, by an estimated 35%, which made living in China seem relatively cheap compared to other countries.
Disadvantages of a Currency Peg
A currency peg must have a fairly sound foundation in reality, as well as strong official backing, to be effective in producing the desired results. A lack in either of those two areas could have adverse economic consequences for all nations involved.
Monetary Policy Setbacks
A currency peg also reduces the pegging country’s ability to set an appropriate monetary policy, especially when its interest rates need to track those of the peg currency country. This factor could adversely impact inflation levels if one country requires economic stimulus, but the other has a strong and inflationary economy. Since central banks need to maintain large reserves to defend the peg, this can also boost inflation.
If a peg is set too low or too high, the possible currency imbalances could defeat the purpose of the peg and the cost of defending the pegged exchange rate could outweigh the benefits to international trade.
In practice, pegging a currency at too low a rate tends to depress domestic living standards, hurt foreign businesses and boost international trade tensions. Conversely, setting a peg at too high an exchange rate tends to promote the domestic overconsumption of imports and can spark substantial inflation when the peg ultimately fails.
Why Countries Peg Their Currency to the U.S. Dollar
Many countries traditionally pegged their currencies to the U.S. dollar when it was on the gold standard as part of the post-WWII Bretton Woods system of fixed currency exchange rates. Although the dollar is no longer convertible to gold, it remained the preeminent reserve currency worldwide even after the collapse of the Bretton Woods system in the 1970s.
A significant number of countries still either peg their currencies to or maintain an artificially reduced trading range versus the U.S. dollar, sometimes for different reasons. For example, quite a few Middle Eastern countries like Saudi Arabia, Bahrain, Jordan, Lebanon, Qatar, the United Arab Emirates and Oman peg their currencies to the dollar since they do a lot of business in oil that is traded in dollars.
In Asia, both Hong Kong and Macau peg their currencies to the U.S. dollar. China used to maintain a dollar peg as well, but it now uses a managed floating exchange rate policy relative to a basket of currencies instead.
A few African countries like Djibouti and Eritrea also peg their currencies to the dollar, as do some nations situated close to the U.S. like Belize, Panama and Cuba. Several Caribbean nations, including Aruba, Bahamas, Barbados and Bermuda, also peg their currencies to the dollar since their economies depend heavily on U.S. tourism.
Significance for Forex Traders
Understanding currency pegs is important for trading in the forex market. Currency pegging was used in the past to manage exchange rates and control currency values, but it has advantages and disadvantages. China's pegging of the renminbi to the U.S. dollar has benefited international trade. However, currency pegs require strong foundations, official support and appropriate monetary policies to be effective. Some countries have moved towards managed floating exchange rate policies. The interplay of currencies and exchange rate policies remains important for speculators.
Frequently Asked Questions
What does peg to USD mean?
If a country pegs its currency to the U.S. dollar or USD, then its central bank or monetary authority will routinely intervene in the forex market to maintain a relatively stable or even fixed exchange rate for its currency versus the dollar.
Is currency pegging good?
Pegging a currency reduces exchange rate risk for businesses involved in international trade, and doing so at a high level of devaluation can make a country’s goods artificially cheap, which can in turn increase its competitiveness in international markets. Since currency pegs tend to create trade imbalances, however, it can result in tensions with the governments of other countries.
Why do you peg a currency?
Currencies are pegged to keep their value stable against the currencies of one or more trading partners. This practice can be done to increase trade competitiveness in foreign markets, as well as to reduce the exchange rate risk arising from foreign tourism or the trade in key commodities like oil.
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