What Is a Currency Peg?
A currency peg is a country or government's exchange rate policy whereby it attaches, or links, the central bank's rate of exchange to another country's script. 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.
How Does a Currency Peg Work?
Currency Peg Deconstructed
Countries commonly peg their money to the currencies of others, typically, the U.S. dollar, the euro, or sometimes to the gold price. Currency pegs create stability between trading partners and can remain in place for decades. For example, the Hong Kong dollar is pegged to the U.S. dollar beginning in 1983, and Denmark's krone is pegged to the euro (since 1982). The practice is also referred to as a fixed exchange rate or pegging.
- A currency peg is used to stabilize the exchange rate between countries often to the advantage of large importers.
- A pegged currency remains low artificially, which creates an anti-competitive trading environment compared to a floating exchange rate.
- U.S. manufacturers consider that the yuan's peg to the dollar allows the Chinese to provide low-priced goods at the expense of U.S. jobs.
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, which means that central banks will need to hold huge volumes of money to avoid excessive buying or selling of their currency that is considered volatile. Currency pegs affect forex trading by artificially stemming volatility.
One disadvantage of a pegged currency is that the value of the money is kept artificially low creating an anti-competitive trading environment compared to a floating exchange rate. Domestic manufacturers support this argument in the United States in the case of the yuan peg to the dollar. These manufacturers consider those low-priced goods, partially the result of an artificial exchange rate is 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 a peg breaks. Major currency fluctuations in the British pound in 1992, the Russian ruble in 1997, and the Argentinean corralito in 2002 followed broken pegs.
Real World Example
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 when the country switched to a basket of 13 currencies, but China discreetly switched back in January 2016.
As an exporter, China benefits from a relatively weak currency, which makes its exports less expensive compared to exports from competing countries. China pegs the yuan to the dollar because the United States was China's largest import partner at $540 billion in 2018, according to the U.S. Census Bureau.
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.