What is a currency peg?
A currency peg refers to a policy where a country’s government or central bank fixes an exchange rate for its currency with respect to a foreign currency or a group of different currencies. This is done to stabilize the exchange rate among various countries. Visit multibankfx.com
The currency exchange rate essentially indicates the value of one currency against another. Though there are certain currencies that are free-floating and the rates keep fluctuating on the basis of how supply and demand play out in the market, many others are fixed and pegged to a different foreign currency.
Pegging makes it possible to anticipate what the exchange rates would look like in the long run. This is important for planning business strategies and boosting economic stability.
Components of a currency peg
- #1 – Domestic Currency
Domestic currency can be identified as the legally acceptable unit or the monetary instrument used as a means of exchange within a country.
- #2 – Foreign Currency
Similar to domestic currency, foreign currency is yet another legal and acceptable instrument of monetary exchange which holds value outside a country. A nation may have reserves of foreign currency to facilitate monetary exchange and recordkeeping.
- #3 – Fixed Exchange Rate
It is known as the exchange rate that is fixed between two nations to support their trade. In a system where the exchange rate is fixed, the central bank is responsible for aligning the national currency with the other currency. This is useful in keeping the exchange rate’s area good and narrow.
Advantages of currency pegs
Currency pegs have gained a lot of popularity now. Nearly 1/4th of the nations around the world have their currencies pegged to another leading currency such as the US dollar or the euro.
But it is also worth mentioning that the currency peg has led to the downfall of many nations. One such example is Argentina which has become bankrupt while on the other hand there’s China has used the same strategy to reach economic heights. This makes it clear that it is a strategy with both pros and cons and we’ll talk about both of them in this piece.
- Solid Basis for Planning:
Currency pegs help governments get a solid ground to plan national finances. Governments would need to purchase essential commodities like oil and food grains from the international market. This is where the national expenses are required to be paid in foreign currency. In most cases, the foreign currency used as the form of exchange is the United States dollar as it functions as the reserve currency of the world. Now that things have changed in the international markets, payments can even be made in euros.
Irrespective of whether it is the USD or the euro, a government must convert the local currency into either of these two to make purchases and to carry out trade. Thus, if the currency rates are not stable, it becomes difficult for a government to estimate how much of the local currency would be sufficient to meet the needs. However, if the currency is pegged, governments are in a better position to make a plan for their revenues and expenditures in their own national currencies without worrying about their volatility.
- Credible Monetary Policy:
Currency pegs are prevalent in third-world nations. Countries with weak economies such as a few in South America, Asia, and Africa are known to have used currency pegs. A major reason for this is also the high rate of corruption in these countries. Therefore it is hard to trust the political leaders of these nations with a reliable monetary policy. Understandably, these nations often choose to outsource their monetary policy to developed nations which would have policymakers who are likely to be better decision-makers.
- Reduced Volatility:
It is not just the governments that benefit from currency pegs, they also work in favour of local businesses. Local businesses are able to anticipate the way their products will be priced in the global market. As soon as they’re able to assess the exact pricing, they could take a shot at speculating the quantities that may be demanded. Since they are not exposed to any market volatility, they can safeguard themselves from foreign exchange losses. This often gives them an edge over competitors who may be exposed to these risks and also need to take into account a risk premium in their prices.
Disadvantages of currency pegs
- Increased Outside Influence:
The downside of using currency pegs is that the nations that use this strategy may find a lot of foreign influence in their internal affairs. It happens because another nation is responsible for its monetary policy which may lead to conflicts.
- Difficulty in Auto Adjustment:
A floating currency system causes the deficits to get auto-adjusted. For example, if a nation is importing a lot, it will also need to pay accordingly. Next, it may cause a fall in the currency supply which could lead to deflation. Deflation indicates low prices and low prices could imply competitive exports.
Therefore, if you increase imports it would also imply that the exports have increased as a freely floating system would keep moving towards equilibrium. Also, note that currency pegs have the tendency to exaggerate disequilibrium. Look at the way the trade and current account deficits lie between the United States and China. The root cause behind this is the peg between the USD and the Yuan. Hence, currencies which are pegged to another currency are likely to face disequilibrium.
- Speculative Attacks:
Speculative attacks on a currency could take place when it moves away significantly from its value. Typically, freely floating currencies tend to not move away or deviate a lot from their original. If they do deviate, the market mechanism comes into the picture and corrects itself immediately UAE.
- The central bank keeps a reserve of foreign currency to facilitate easy purchase and sale of reserves at a fixed rate of exchange.
- When a country has spent all of its foreign reserves, the currency peg becomes invalid.
- This causes currency devaluation and the exchange rate becomes free floating.