A pegged exchange rate involves a country fixing the value of its currency to another currency, a mix of currencies (often referred to as a ‘basket’ of currencies) or a commodity like gold.
Nations do it to bring stability, control inflation and improve investor confidence, but it’s not always plain sailing.
In this article, we’ll dive deep into what a pegged exchange rate is, how it works, why countries do it, and the pros and cons of doing so.
Table of contents
- What is a pegged currency?
- Breaking down a pegged exchange rate
- How do pegged exchange rates work?
- Why do countries peg their currency?
- What are the disadvantages of a pegged exchange rate?
- Examples of pegged currencies
- Summing up pegged exchange rates
- 10 FAQs about pegged exchange rates
What is a pegged currency?
As touched on above, in finance, pegging refers to the practice of fixing the exchange rate of a country’s currency to another currency, a basket of currencies, or gold.
Currency exchange rate refers to the value of one currency against another. An example is Great British pounds (GBP) against United States dollars (GBP), displayed as GBP/USD. If the value of GBP/USD is 1.27, it means 1 GBP will get you 1.27 USD.
The main reason countries peg their currency is to bring stability to exchange rates, preventing any sudden or significant shifts in value.
By doing so, foreign businesses and investors can be more confident of the price they’ll pay for the country’s currency, protecting trade and investment.
Breaking down a pegged exchange rate
A pegged exchange rate is a system where a country’s currency value is tied to another currency at a fixed rate.
For example, a country might set its currency to always be worth a specific amount relative to dollar or the euro (EUR).
Central banks are responsible for maintaining this fixed exchange rate by intervening in the foreign exchange (FX) market when needed.
USD is typically a popular pegging choice as it’s widely regarded as a stable, safe-haven currency.
A safe-haven currency often holds or increases in value during times of economic and geopolitical uncertainty. The dollar, for example, increased in value against other major currencies as Covid-19 lockdowns were announced in Europe during the spring of 2020.
Read: What causes currency appreciation and depreciation?
How do pegged exchange rates work?
When a country pegs its currency, the central bank must manage the exchange rate by buying or selling reserves of foreign currency.
If the domestic currency weakens below the pegged rate, the central bank buys up its own currency to drive up its value.
On the other hand, if the currency strengthens above the pegged rate, the central bank sells its currency to lower its value.
However, this can come with challenges. Maintaining a peg can deplete a country’s foreign reserves if the central bank is forced to get involved frequently.
Additionally, a fixed exchange rate means the country gives up some control over its monetary policy, which can be an issue during economic crises.
Why do countries peg their currency?
There are several reasons why a country might introduce a pegged exchange rate. But while they can bring a range of benefits, a pegged currency does come with its flaws.
Firstly, let’s analyse the benefits of pegging a currency. Here’s why countries do it:
- Stability in trade: Countries that rely heavily on exports might peg their currency to the currency of a major trading partner to stabilise trade prices. This ensures that their products remain competitively priced in that partner’s market.
- Inflation control: Pegging to a stable currency can help a country control inflation by ensuring that the value of their currency doesn’t devalue too quickly.
- Economic confidence: A pegged currency can boost investor confidence, making the country appear more stable and reliable for foreign investment.
What are the disadvantages of a pegged exchange rate?
While the benefits of a pegged currency are clear, there are some drawbacks. Here are some of the disadvantages:
- Loss of monetary policy control: When a country pegs its currency, it loses some control over its monetary policy because it must prioritise maintaining the peg over other economic objectives.
- Depletion of reserves: Maintaining a currency peg requires significant foreign reserves. A central bank may need to use these reserves to defend the peg, which can be costly and unsustainable in the long run.
- Vulnerability to external shocks: If currency a country is pegged to experiences significant volatility, it can have negative knock-on effects on the pegged currency, even if the country’s domestic economy is strong.
Read: What are restricted and exotic currencies?
Examples of pegged currencies
As mentioned above, countries peg their currencies to bring stability, control inflation and boost economic confidence.
Let’s dive into some real-world examples of currency pegs.
The Hong Kong dollar (HKD) peg
Hong Kong is one of the most well-known examples of a currency peg. Since 1983, the Hong Kong dollar (HKD) has been pegged to the US dollar at a range of 7.75 and 7.85 HKD to 1 USD.
The purpose of this peg was to maintain economic stability and confidence during a time of political uncertainty before Hong Kong’s handover from the United Kingdom to China in 1997.
The peg has helped keep inflation low and Hong Kong’s financial system stable, but it has also limited the region’s monetary policy flexibility.
The Chinese yuan (CNY) peg
In 1994, China pegged its currency, the renminbi (RMB) (now also referred to as the yuan (CNY)), to the US dollar at a rate of 8.28. This allowed China to keep its exports competitively priced in international markets.
However, under pressure from global trading partners, China began to allow the renminbi to float more freely in 2005. While the currency is no longer strictly pegged, it’s still heavily managed by the People’s Bank of China.
This controlled float allows China to benefit from some flexibility while maintaining influence over its currency’s value.
The Gulf States’ Peg
Several countries in the Gulf Cooperation Council (GCC), including Saudi Arabia, the United Arab Emirates, Bahrain, Oman, Qatar, and, for a time, Kuwait have pegged their currencies to the US dollar.
Most of the GCC nations have pegged their currencies to the dollar since the 1980s. The key reason was to reduce FX risk due to a heavy reliance on revenue from oil, which is internationally priced in USD.
A stable exchange rate with the USD helps them avoid the negative effects of currency fluctuations on oil revenues.
Summing up pegged exchange rates
In this article, we’ve explained why countries peg their currency, what the pros and cons are and looked into some real-world examples.
They’re crucial for bringing stability to exchange rates, resulting in economic stability, inflation control and improved investor confidence.
However, countries that decide to peg their currency run the risk of losing monetary policy control and become more vulnerable to external shocks.
The examples we looked at, such as the Hong Kong and Chinese pegs to the US dollar, showed both the positive and negative sides of a fixed exchange rate.
They highlight why managing FX risk is so important and showcase the lengths some countries are willing to go to do so.
The same applies to businesses, too. Sudden or significant changes to currency values can have serious consequences to profits and budgeting.
At Privalgo, we specialise in managing FX risk. Our solutions can protect your business from the negative impact of currency movements and help you capitalise on potential opportunities.
Our team is experienced in helping clients navigate a vast range of currencies, including those with a pegged exchange rate.
Get in touch with our team of currency specialists to find out more.
10 FAQs about pegged exchange rates
Below are 10 frequently asked questions about currency pegs. Some include information already discussed in this article.
1. Which countries peg their currency?
66 countries currently peg their currencies to the US dollar. Some examples include:
- Bahrain
- Belize
- Djibouti
- Eritrea
- Hong Kong
- Jordan
- Lebanon
- Oman
- Panama
- Qatar
- Saudi Arabia
- United Arab Emirates
2. Is the British pound a pegged currency?
No, the British pound (GBP) is not currently pegged to any other currency. It operates on a floating exchange rate, meaning its value is determined by the forex market based on supply and demand.
3. Does China still peg its currency?
China no longer strictly pegs its currency, the yuan (CNY), to the US dollar as it did in the past. Since 2005, China has allowed its currency to float more freely, though it is still heavily managed by the People’s Bank of China within a controlled range.
4. What is the US currency peg?
The US dollar itself is not pegged to any other currency; it operates on a floating exchange rate. However, the US dollar is often used as the anchor currency for other countries’ pegs due to its stability and status as the world’s primary reserve currency.
5. Why do countries peg their currency?
Countries peg their currency to another currency or a basket of currencies to bring stability to exchange rates, control inflation, and boost investor confidence. This helps protect trade and investment by ensuring predictable currency values.
6. What are the pros of a pegged exchange rate?
The pros of currency pegging include exchange rate stability, which can boost international trade and investment; inflation control, particularly when pegging to a stable currency; and improved investor confidence in the country’s economy.
7. What are the cons of a pegged exchange rate?
The cons of currency pegging include a loss of control over monetary policy, as maintaining the peg becomes the priority; depletion of foreign reserves due to the need to defend the peg; and vulnerability to external shocks from the anchor currency’s fluctuations.
8. How does currency pegging help control inflation?
By pegging to a stable or strong currency, a country can help prevent its own currency from devaluing too quickly, which in turn helps control inflation. This is particularly beneficial for countries with volatile economies.
9. What role does the central bank play in maintaining a pegged exchange rate?
The central bank is responsible for maintaining the pegged exchange rate by intervening in the foreign exchange market. It buys or sells its currency to keep it within the target range relative to the anchor currency.
10. Can a pegged currency system fail?
Yes, a pegged currency system can fail if the central bank runs out of foreign reserves to defend the peg or if the country faces economic or political pressures that make maintaining the peg unsustainable. Historical examples include Argentina’s failed peg to the US dollar in the early 2000s.
