Currency exchange rates make up a very important part of a nation's economy. The exchange rate is the value of the currency compared to another one. The value of some currencies is free-floating. This means they fluctuate based on supply and demand in the market, while others are fixed. This means they are pegged to another currency.
In this article, we discuss exchange rates that are pegged to the U.S. dollar as well as some of the benefits of taking on this strategy.
- There are two types of currency exchange rates—floating and fixed.
- The U.S. dollar and other major currencies are floating currencies—their values change according to how the currency trades on forex markets.
- Fixed currencies derive value by being fixed or pegged to another currency.
What Does Pegging Mean?
When countries participate in international trade, they need to ensure the value of their currency remains relatively stable. Pegging is a way for countries to do that. When a currency is pegged, or fixed, it is tied to another country's currency. Countries choose to peg their currency to safeguard the competitiveness of their exported goods and services. A weaker currency is good for exports and tourists, as everything becomes cheaper to purchase.
The wider the fluctuations in currencies, the more detrimental it can be to international trade. Many countries, though, chose to maintain a fixed policy, and today, there are still a significant number of currencies pegged to the U.S. dollar.
Countries peg to ensure their goods and services remain competitive instead of being negatively impacted by the constant fluctuation of a floating currency’s exchange rate.
Bretton Woods Agreement
The greenback, as the U.S. dollar is commonly known, was pegged to gold under the Bretton Woods Agreement as the United States held most of the world's gold reserves. This system cut back the volatility in international trade relations as most currencies were pegged to the U.S. dollar. This agreement was ended by President Richard Nixon in the early 1970s.
Once the system collapsed, countries were free to choose how their currencies would work in the foreign exchange market. They were able to peg it to another currency, a currency basket, or let the market determine the currency's value.
Fixed vs. Floating Currencies
Today, there are two types of currency exchange rates that are still in existence—floating and fixed. Major currencies, such as the Japanese yen, euro, and the U.S. dollar, are floating currencies—their values change according to how the currency trades on foreign exchange or forex (FX) markets. This type of exchange rate is based on supply and demand. This rate is, therefore, determined by market forces compared to other currencies. Any changes in currency pricing point to strength in the economy, while short-term changes may point to weakness.
Fixed currencies, on the other hand, derive value by being fixed to another currency. Most developing or emerging market economies use fixed exchange rates for their currencies. This provides exporting and importing countries more stability, and also keeps interest rates low.
Why Currencies Peg to the U.S. Dollar
Countries have different reasons for pegging to the dollar. Most of the Caribbean islands—Aruba, Bahamas, Barbados, and Bermuda, to name a few—peg their currencies to the U.S. dollar because their main source of income is derived from tourism paid in dollars. Fixing to the U.S. dollar stabilizes their economies and makes them less volatile.
In Africa, many countries peg to the euro. The exceptions being Djibouti and Eritrea which peg their own currencies to the U.S. dollar. In the Middle East, many countries including Jordan, Oman, Qatar, Saudi Arabia, and the United Arab Emirates peg to the U.S. dollar for stability—the oil-rich nations need the United States as a major trading partner for oil.
In Asia, Macau and Hong Kong fix to the U.S. dollar. China, on the other hand, has been embroiled in controversy about its currency policy. While China does not officially peg the Chinese yuan to a basket of currencies that includes the U.S. dollar, China does manage the exchange rate of yuan to dollars so as to benefit its export-driven economy.
Major Fixed Currencies
Below is a list of some of the national economies and the corresponding rates that currently peg to the U.S. dollar as of June 2021:
|Major Fixed Currencies|
|Country||Region||Currency Name||Code||Peg Rate||Rate Since|
|Cuba||Central America||Convertible Peso||CUC||1.000||2011|
|Saudi Arabia||Middle East||Riyal||SAR||3.75||2003|
|United Arab Emirates||Middle East||Dirham||AED||3.673||1997|
The Bottom Line
It makes sense for many small nations to fix their currency to the U.S. dollar, especially if the primary source of revenue comes in the form of the dollar. This pegged strategy helps stabilize and secure small economies which may otherwise be unable to withstand volatility.
Conversely, large and growing economies will find it hard over time to maintain a fixed currency policy, which will eventually snowball into an outsized need to buy more and more dollars to maintain the proper ratio.