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What is a 'Currency Peg'?

A currency peg is a country or government's exchange rate policy whereby it attaches, or pegs, 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, a currency peg stabilizes the exchange rate between countries. Doing so provides long-term predictability of exchange rates 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, typically, the U.S. dollar or the euro. Currency pegs create stability between trading partners and can remain in place for decades. For example, the Hong Kong dollar has been pegged to the U.S. dollar since 1983, and Denmark's krone has been pegged to the euro since 1982.

Example of a Currency Peg

An example of a mutually beneficial currency peg is China’s yuan link to the U.S. dollar. The peg has been in place for a long time, 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 relatively less expensive compared to exports from competing countries. China pegs the yuan to the dollar because the United States is China's largest import partner at $478.8 billion in 2016. In 2015, 18% of China's exports were to the United States.

The stable exchange rate in China 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 developing prototypes and investing in the manufacturing and importing of goods with the understanding 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 realized from cheaper Chinese imports in dollars can have a significant impact on the bottom line. Profit margins in the retail sector are typically in the low single digits.

Disadvantages of Pegged Currencies

One disadvantage of a pegged currency is that the currency is kept artificially low creating an anti-competitive trading environment compared to a floating exchange rate. This argument is supported by domestic manufacturers in the United States in the case of the yuan peg to the dollar. These manufacturers consider that low-priced goods, partially the result of an artificial exchange rate, are costing jobs in the United States.

Another disadvantage is that a currency peg can minimize currency fluctuations, but growing imbalances between the country that pegs a currency and the target country can be problematic when the peg is broken. Broken pegs were followed by major currency fluctuations in the British pound in 1992, the Russian ruble in 1997 and the Argentinean corralito in 2002.

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