What is a Currency Peg?
A currency peg is when the government or monetary authority of a country fixes a specific exchange rate with a foreign country’s currency. A currency peg could also be with reference to a set of currencies or with reference to other widely traded commodities.
A currency peg is typically used to ensure the stability of the exchange rate between two countries, especially those that frequently trade with each other. A common example is the dollar peg, which over 50 countries have adopted since the dollar is one of the more stable currencies globally.
Advantages of a Currency Peg
- A currency peg prevents excessive volatility in a country’s currency due to market conditions and hence prevents a potential currency crisis.
- Investments and trading also become easier between the two countries when their currencies are pegged.
- Businesses benefit from a stable exchange rate, as their international customers do not need to hedge for forex risk.
- A currency peg maintains the competitiveness of a country’s exports (for example, Vietnam) for major importing destinations, such as the US and EU, as sourcing costs remain fixed.
- Similarly, weaker countries benefit from currency pegs as their imports from countries, such as the US or the EU, remain at a constant price.
- It disciplines the monetary authority in a country.
Disadvantages of a Currency Peg
- In the case of sizeable fluctuations in the reference currency or commodity, the domestic currency also experiences significant volatility.
- If a currency is pegged at an overly low exchange rate, it deprives domestic customers the purchasing power of buying foreign goods.
- If a currency is pegged at too high a rate, domestic companies will import more than they produce.
- A currency peg can leave a country at risk to speculators, who can short the currency and hence drive down its value.
