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 are 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.

Key Takeaways

  • 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 it does not officially peg the Chinese yuan to a basket of currencies that include the U.S. dollar, it does manage it through to benefit its manufacturing and 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 October 2018.

 

Country

 

Region

 

Currency Name

 

Code

 

Peg Rate

 

Rate Since

 

Bahrain

 

Middle East

 

Dollar

 

BHD

 

0.376

 

2001

Belize Central America Dollar BZ$ 2.00 1978
 

Cuba

 

Central America

 

Convertible Peso

 

CUC

 

1.000

 

2011

 

Djibouti

 

Africa

 

Franc

 

DJF

 

177.721

 

1973

 

Eritrea

 

Africa

 

Nakfa

 

ERN

 

15.000

 

2005

 

Hong Kong

 

Asia

 

Dollar

 

HKD

 

7.84

 

1998

 

Jordan

 

Middle East

 

Dinar

 

JOD

 

0.71

 

1995

 

Lebanon

 

Middle East

 

Pound

 

LBP

 

1507.5

 

1997

 

Oman

 

Middle East

 

Rial

 

OMR

 

0.385

 

1986

 

Panama

 

Central America

 

Balboa

 

PAB

 

1.000

 

1904

 

Qatar

 

Middle East

 

Riyal

 

QAR

 

3.64

 

2001

 

Saudi Arabia

 

Middle East

 

Riyal

 

SAR

 

3.75

 

2003

 

United Arab Emirates

 

Middle East

 

Dirham

 

AED

 

3.673

 

1997

Source: The World Bank

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.