What is a 'Currency Peg'
A currency peg is a country or government's exchange-rate policy of attaching, or pegging, the central bank's rate of exchange to another country's currency. Also referred to as a fixed exchange rate or a pegged exchange rate, currency pegs stabilize the exchange rate between countries, which allows for accurate long-term predictability for business planning and can anchor rates at advantageous levels for large importers.
BREAKING DOWN 'Currency Peg'Countries commonly peg their currencies to the currencies of others, most often the U.S. dollar or the euro. Currency pegs add predictability between trading partners and can remain in place for decades, such as the linkage of the Hong Kong dollar to the U.S. dollar, which has remained steady since 1983; Denmark's peg of the kroner to the euro since 1982 is another notable example.
Currency Peg Example
An example of a mutually beneficial currency peg is China’s linkage of the yuan to the U.S. dollar. The peg has been in place for years, is range-bound and has its detractors as well as supporters. China briefly decoupled from the dollar in December 2015, switching to a basket of 13 currencies, but discreetly switched back in January 2016.
As an exporter, China benefits from a relatively weak currency, which makes its exports less expensive on an absolute basis as well as in comparison to the exports from competing countries. The logic behind China’s peg of the yuan to the dollar is based in large part on the United States being its largest import partner at $410.8 billion in 2015, representing 18% of the country’s exports for the year.
The stable exchange rate and a weak yuan also benefit specific businesses in the United States. For example, stability allows businesses to engage in long-term planning, such as ordering prototypes, setting up manufacturing and importing goods with the knowledge that costs will not be affected by currency fluctuations.
The weak yuan also benefits major importers, such as Walmart Stores, Inc. and Target Corporation. For these and other retailers, the savings resulting from paying for Chinese imports in dollars can have a major impact on the bottom line, considering profit margins in this sector typically run in the low single digits.
Disadvantages of Pegged Currencies
The first disadvantage is pegs which keep currencies artificially low create an anti-competitive trading environment when compared to floating rates. This argument has largely been focused on the peg of the yuan to the dollar by domestic manufacturers stating that low-priced goods, partially due to an artificial exchange rate, are costing jobs in the United States.
The second disadvantage is pegs can minimize currency fluctuations, but growing imbalances between the country pegging the currency and the target country can result in large and problematic moves when pegs are broken. Examples of broken pegs followed by major currency fluctuations include the British pound in 1992, the Russian ruble in 1997 and Argentinean corralito in 2002.