What Is a Currency Exchange Rate Peg?

A currency exchange rate peg is a financial arrangement in which a country’s government commits to maintaining the value of its currency within a specific range. The peg can be either fixed or floating, but the goal is to stabilize the economy and make it more attractive for foreign investors. 

This can be an effective way for countries with less stable economies to find economic stability and growth, but it can also lead to problems if not done right. 

So, how does a currency exchange rate peg work, and what are the pros and cons?

Let’s find out below.

 

How Currency Exchange Rate Peg Works

Primarily, a currency peg uses a fixed exchange rate and rarely a floating one. In this scenario, a currency is pegged to another currency at a specific exchange rate. The country’s central bank then commits to buying and selling its currency in the foreign exchange market should it need to do so.

The country vouching for currency exchange rate peg will manage its currency to remain equal to the currency which is being pegged. 

This means that there will be no tendency for appreciation or depreciation, and hence a balance can be maintained between both currencies.

A country will establish a currency peg with a country with a broader or stable economy than they do. For instance, most countries would peg their currencies against the Euro or the U.S. dollar.

 

The Benefits of Currency Exchange Rate Pegs

A currency exchange rate peg has several benefits. The most common ones include:

 

Expands Trade and Boosts Real Income

A currency exchange rate peg can help to expand trade due to its stability. This is because currency-pegged nations are not subject to currency fluctuations that could potentially harm their economy or business exchanges.

As a result, currency pegs have been very popular in Africa and the Caribbean, where they facilitate access of local products into foreign markets with ease. The currency exchange rate peg also leads to an increase in real income or the actual purchasing power.

 

Increases Foreign Direct Investment (FDI)

A currency exchange rate peg increases foreign direct investment by encouraging stable economic conditions for long-term growth and international commerce. This is precisely why currency pegs are especially popular among developing nations with growing economies.

 

Increase Fiscal Stability and Liquidity Near Peg

Currency pegs also increase financial stability and liquidity near or at parity by rendering currencies more stable. This currency stability, of course, is one of the currency peg’s biggest benefits because currency volatility can be devastating to a country’s fiscal health and economic growth.

 

Decrease in Speculation and Uncertainty

Currency speculation involving currency pegs decreases because currency pegs remain stable over time due to their static nature. For example, currency traders are much less likely to engage in currency speculation when they know that a currency will remain fixed within certain boundaries at all times.

 

Increase in Investment and Economic Growth

Finally, currency pegs have been shown to increase investment and economic growth. This is primarily attributed to the increased stability of currency pegs. Whether individuals or businesses, investors tend to be more confident in countries with currency pegs because there is a much lower risk of currency devaluation and subsequent losses.

 

Reduced Volatility

Currency pegs also reduce currency volatility, which, in turn, leads to more investment. Currency traders know that a currency will remain fixed within certain boundaries at all times, which allows currency traders and investors to make more informed decisions.

 

Pegged Currency Means Low Exchange Rate Risk

A currency exchange rate peg is a fixed relationship between two currencies. This means that the value of one currency will always be equivalent to some amount of the other currency. The low exchange rate will significantly reduce the investment risk for investors and businesses involved in international trade.

 

Establishment of Disciplined Monetary Policies

Most of the countries that go for currency pegs are developing countries. Many of these countries strive to get their financial policies from developed countries that make more responsible monetary decisions.

 

The Disadvantages of Currency Exchange Rate Pegs

Despite the numerous benefits that come with currency pegs, they are not without disadvantages. Some of the critical disadvantages are:

 

It is Likely to Spike Supply and Demand

When a country pegs its currency, there’s a likelihood of a spike in supply and demand. For example, this can happen when a currency peg is suddenly lifted, and the currency’s value changes drastically overnight — as it often does when pegs are abolished.

 

Central Banks Have to Maintain a Large Amount of Cash Reserves

A currency peg requires the central bank to maintain a large number of cash reserves. This is mainly because some countries require that their currency be pegged to more than one currency. 

Such an arrangement may not necessarily benefit those economies because it forces them to hold on to some other currencies they’re not using. Doing this can increase inflationary pressure within the economy if they’re not careful. 

 

Increased Foreign Interference

Once a country commits to pegged currency exchange rates, they’re most likely to surfer foreign influence in their domestic matters. 

For instance, if a currency peg is pegged to the U.S. dollar, they’re likely to face more pressure from international markets dominated by American interests. This can create problems when it comes to domestic matters that are important for their own nation’s economy.

Some countries might even be forced out of oil deals because the price per barrel is set in U.S. currency. This can destabilize the whole country’s economy if they’re not careful with their currency peg rates.

 

Predetermined Values Can Be Bad for the Economy

A currency exchange rate pegged system can be helpful, but it doesn’t work for every nation and shouldn’t replace a solid economic plan for growth. Countries need to set their currency exchange rates on the market, not through a predetermined rate that might have been agreed upon earlier before they were even involved.

In this case, countries must look into how inflationary or deflationary trends affect their currency and any risk of currency devaluation.

When using a currency peg, the countries involved have to be wary of what’s going on in their economy and how it will affect their currency peg. 

If they’re not sure about this beforehand, there could be problems down the road for both economies when making decisions. It can lead to currency devaluation and destabilization, which is never a good thing for an economy.

Some currency exchange rate pegs can be pegged to multiple currencies at once, such as the currency of their largest trading partner or something like this instead. This will make it more stable on average, but there’s still no guarantee that everything will go according to plan.

 

Bottom Line

Currency exchange rate pegs are a great way to maintain currency stability in an economy. However, there can still be some problems that arise from this kind of currency system. The problems always occur, especially if the country or organization doesn’t have a firm grasp on its currency’s value and how it will fluctuate with other currencies over time.