A currency peg, also known as a fixed exchange rate, is a monetary policy where a country ties the value of its currency to that of another currency, a basket of currencies, or a commodity such as gold.
This ensures a stable exchange rate between the pegged currency and its reference, fostering trade and investment by reducing currency volatility.
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How a Currency Peg Works
In a currency peg system, the central bank intervenes in the foreign exchange market to maintain the fixed exchange rate. This involves:
1. Buying or Selling Foreign Reserves
To prevent the currency from deviating, the central bank either buys its own currency using foreign reserves (if the currency is under pressure to weaken) or sells its own currency (if it is under pressure to strengthen).
2. Adjusting Interest Rates
Central banks may also use monetary policy tools, such as altering interest rates, to support the peg.
3. Regulating Capital Flows
Some governments impose capital controls to manage the movement of funds that could destabilize the peg.
Types of Currency Pegs
1. Hard Peg
The exchange rate is permanently fixed to the reference currency, with little or no flexibility.
Example: The currency board system used by Hong Kong, which pegs the Hong Kong dollar to the U.S. dollar.
2. Soft Peg
The exchange rate is fixed but with some allowable fluctuation within a specific band.
Example: The Chinese yuan was previously pegged to the U.S. dollar within a narrow band.
3. Commodity Peg
The currency is pegged to a commodity such as gold.
Example: The gold standard that many countries followed in the 19th and early 20th centuries.
Reasons for Adopting a Currency Peg
1. Promoting Trade Stability
A stable exchange rate reduces uncertainty for businesses involved in international trade.
2. Attracting Foreign Investment
Investors are more confident when a country’s currency is stable and not subject to extreme fluctuations.
3. Curbing Inflation
Pegging to a stable currency (like the U.S. dollar) can help control inflation in countries with volatile economies.
4. Maintaining Competitiveness
A currency peg can keep exports competitively priced, supporting economic growth in export-driven economies.
Advantages of a Currency Peg
1. Exchange Rate Stability
Reduces volatility, making it easier for businesses to plan and budget for cross-border transactions.
2. Inflation Control
By anchoring to a stable currency, a country can import monetary discipline and reduce inflationary pressures.
3. Encourages Investment
Stability in the exchange rate attracts long-term foreign investments.
4. Boosts Trade Relations
Facilitates smoother trade with the reference currency’s country.
Disadvantages of a Currency Peg
1. Loss of Monetary Policy Independence
The central bank cannot freely adjust interest rates or money supply to address domestic economic needs.
Maintaining the peg requires substantial foreign exchange reserves, which may be depleted during a crisis.
3. Overvaluation or Undervaluation
Pegged rates may not reflect the actual value of the currency, leading to trade imbalances.
4. Speculative Attacks
If investors believe the peg is unsustainable, they may bet against the currency, creating further pressure.
Examples of Currency Pegs
Pegged to the U.S. dollar at a rate of approximately 7.8 HKD/USD under a currency board arrangement.
2. Saudi Riyal (SAR)
Pegged to the U.S. dollar at 3.75 SAR/USD to stabilize its oil-export-driven economy.
Historically pegged to the U.S. dollar but now operates under a managed float system with a reference basket of currencies.
4. Bahraini Dinar (BHD)
Pegged to the U.S. dollar to maintain economic stability in the region.
Challenges of Maintaining a Currency Peg
1. Economic Divergence
If the domestic economy diverges significantly from the reference currency’s economy, maintaining the peg becomes unsustainable.
2. Global Market Pressures
External shocks, such as rising oil prices or global recessions, can destabilize the peg.
3. Political and Social Costs
Defending a peg often requires painful measures like austerity, which can be politically and socially unpopular.
4. Speculative Attacks
Large-scale speculative attacks can force a country to abandon its peg, as seen in the Asian Financial Crisis (1997-1998).
Currency Peg and Floating Exchange Rate
| Aspect | Currency Peg | Floating Exchange Rate |
| Flexibility | Fixed, limited movement | Determined by market forces |
| Central Bank Role | Frequent intervention needed | Minimal intervention |
| Economic Stability | Stable, but rigid | Can be volatile, but adjusts naturally |
| Speculation | High risk of attacks | Speculation is market-driven |
Conclusion
Currency pegs can offer economic stability, especially for nations with small or volatile economies. However, they require careful management and sufficient reserves to withstand economic pressures.
While a peg can stabilize trade and investment, it is not without risks, particularly during economic or political crises. Striking the right balance between stability and flexibility remains key to successfully implementing a currency peg system.
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