What is Currency Peg?

Integration of the world markets enabled free trade and price determination in terms of products, securities and even currencies. Currency trading enabled determination of exchange rate by market demand and supply. However, the central banks of every country want to ensure that speculators do not create excess volatility in the domestic currency making an unnecessary disturbance in the economy and making importer’s and exporter’s susceptible to high foreign currency risk.

Meaning

A currency peg is a governmental policy of fixing the exchange rate of its currency to that of another currency or a basket of currencies, or occasionally to the gold prices. Also referred to as a fixed exchange rate, or pegging. The aim is to stabilize the exchange rate between countries. This provides long term obviousness of exchange rates for short and long term business planning. This is achieved with central bank monitoring supply and demand, releasing or restricting cash flow as the case may be in order to ensure that there are no surprising spikes in demand or supply.

However, a currency peg can be challenging to maintain and distort markets if it is too far removed from the natural market price.

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.
• 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.
• According to the theory of comparative advantage, everyone will be able to spend more time doing what they do best.

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. This would require central bank to hold large forex reserves to counter excessive buying or selling of the domestic 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.
• 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. This might end with government’s reserves exhaustion, and the collapse of the peg eventually.
• 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.