Currency Peg

Reviewed by Athena | Updated on Sep 28, 2020

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

  1. A currency peg prevents excessive volatility in a country’s currency due to market conditions and hence prevents a potential currency crisis.
  2. Investments and trading also become easier between the two countries when their currencies are pegged.
  3. Businesses benefit from a stable exchange rate, as their international customers do not need to hedge for forex risk.
  4. 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.
  5. Similarly, weaker countries benefit from currency pegs as their imports from countries, such as the US or the EU, remain at a constant price.
  6. It disciplines the monetary authority in a country.

Disadvantages of a Currency Peg

  1. In the case of sizeable fluctuations in the reference currency or commodity, the domestic currency also experiences significant volatility.
  2. If a currency is pegged at an overly low exchange rate, it deprives domestic customers the purchasing power of buying foreign goods.
  3. If a currency is pegged at too high a rate, domestic companies will import more than they produce.
  4. A currency peg can leave a country at risk to speculators, who can short the currency and hence drive down its value.