What Is a Currency Peg?

A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a foreign currency or a basket of currencies. Pegging a currency stabilizes the exchange rate between countries. Doing so provides long-term predictability of exchange rates for business planning. However, a currency peg can be challenging to maintain and distort markets if it is too far removed from the natural market price.

Key Takeaways

  • A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a foreign currency or basket of currencies.
  • A realistic currency peg can reduce uncertainty, promote trade, and boost incomes.
  • An overly low currency peg keeps domestic living standards low, hurts foreign businesses, and creates trade tensions with other countries.
  • An artificially high currency peg contributes to overconsumption of imports, cannot be sustained in the long run, and often causes inflation when it collapses.

Understanding Currency Pegs

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How Does a Currency Peg Work?

The primary motivation for currency pegs is to encourage trade between countries by reducing foreign exchange risk. Profit margins for many businesses are low, so a small shift in exchange rates can eliminate profits and force firms to find new suppliers. That is particularly true in the highly competitive retail industry.

Countries commonly establish a currency peg with a stronger or more developed economy so that domestic companies can access broader markets with less risk. The U.S. dollar, the euro, and gold have historically been popular choices. 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.

Only realistic currency pegs aimed at reducing volatility can produce economic benefits. Setting a currency peg artificially high or low creates imbalances that ultimately harm all countries involved.

Advantages of Pegged Exchange Rates

Pegged currencies can expand trade and boost real incomes, particularly when currency fluctuations are relatively low and show no long-term changes. Without exchange rate risk and tariffs, individuals, businesses, and nations are free to benefit fully from specialization and exchange. According to the theory of comparative advantage, everyone will be able to spend more time doing what they do best.

With pegged exchange rates, farmers will be able to simply produce food as best they can, rather than spending time and money hedging foreign exchange risk with derivatives. Similarly, technology firms will be able to focus on building better computers. Perhaps most importantly, retailers in both countries will be able to source from the most efficient producers. Pegged exchange rates make more long-term investments possible in the other country. With a currency peg, fluctuating exchange rates are not constantly disrupting supply chains and changing the value of investments.

Disadvantages of Pegged Currencies

The central bank of a country with a currency peg must monitor supply and demand and manage cash flow to avoid spikes in demand or supply. These spikes can cause a currency to stray from its pegged price. That means the central bank will need to hold large foreign exchange reserves to counter excessive buying or selling of its currency. Currency pegs affect forex trading by artificially stemming volatility.

Countries will experience a particular set of problems when a currency is pegged at an overly low exchange rate. On the one hand, domestic consumers will be deprived of the purchasing power to buy foreign goods. Suppose that the Chinese yuan is pegged too low against the U.S. dollar. Then, Chinese consumers will have to pay more for imported food and oil, lowering their consumption and standard of living. On the other hand, the U.S. farmers and Middle East oil producers who would have sold them more goods lose business. This situation naturally creates trade tensions between the country with an undervalued currency and the rest of the world.

Another set of problems emerges when a currency is pegged at an overly high rate. A country may be unable to defend the peg over time. Since the government set the rate too high, domestic consumers will buy too many imports and consume more than they can produce. These chronic trade deficits will create downward pressure on the home currency, and the government will have to spend foreign exchange reserves to defend the peg. The government's reserves will eventually be exhausted, and the peg will collapse.

When a currency peg collapses, the country that set the peg too high will suddenly find imports more expensive. That means inflation will rise, and the nation may also have difficulty paying its debts. The other country will find its exporters losing markets, and its investors losing money on foreign assets that are no longer worth as much in domestic currency. Major currency peg breakdowns include the Argentine peso to the U.S. dollar in 2002, the British pound to the German mark in 1992, and arguably the U.S. dollar to gold in 1971.