Currency Peg

Article byRishab Nigam
Reviewed byDheeraj Vaidya, CFA, FRM

Currency Peg Meaning

A currency peg is defined as the policy whereby the government or the central bank maintains a fixed exchange rate to the currency belonging to another country, resulting in a stable exchange rate policy between the two. For example, the currency of China was pegged with US dollars until 2015.

Key Takeaways

  • A currency peg is a policy implemented by a government or central bank where a fixed exchange rate is maintained between the domestic currency and another country’s currency.
  • The key components of a currency peg include the domestic currency, the foreign currency to which it is pegged, and the fixed exchange rate between the two.
  • Currency pegs play a crucial role in facilitating foreign exchange trading by providing stability and predictability in exchange rates. However, periodic volatility may still occur.

Components of Currency Peg

Components-of-Holding-Cost

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#1 – Domestic Currency

It is defined as the legally acceptable unit or tender used as the monetary instrument of the exchange in one’s own country or the domestic country. It is the primary currency that may be used as the instrument of exchange within the country’s border.

#2 – Foreign Currency

It is a legal and acceptable tender having value outside the country’s borders. The domestic country may keep it for monetary exchange and recordkeeping.

#3 – Fixed Exchange Rate

It is defined as the exchange rate fixed between two countries to supplement their trade. In such a system, the central bank aligns its domestic currency with its other currency. It helps the exchange rate maintain a good and narrow area.

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Currency Peg Formula

It is computed using the relationship as described below: –

Currency Peg Formula

Here,

  • Dom represents the domestic currency.
  • Xi, Xm, represent
  • s the generic notations.
  • The time is represented as t.
  • I represent the foreign currency.

Currency Peg Examples

Following are the various examples of the currency peg.

Example #1

Suppose a country pegs its currency with the value of gold. Therefore, every time the value of gold increased or decreased, the relative effect on the currency of the domestic country had pegged its currency to gold. The US had huge reserves of gold and therefore added to their advantage when the USA pegged US dollars with the gold.

It also helped them to establish strong international tradeInternational TradeInternational Trade refers to the trading or exchange of goods and or services across international borders. read more. The US developed a comprehensive system that curbed the volatility in the international trade relations wherein major countries pegged their domestic currencies with that of the USA.

Example #2

The currency of China was pegged with US dollars which is foreign currency.

  • In 2015, China broke the peg and separated itself with US dollars.
  • It later established its peg with the currency baskets of 13 countries.
  • The basket of currencies allowed China to have competitive trade relations.
  • The export of china became strong with countries with relatively weaker currency than that of the Chinese currency Yuan.
  • However, certain types of business in the United States gained or thrived due to a weaker Chinese currency Yuan.
  • However, in 2016, it re-established the peg with US dollars.
Currency-peg

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Advantages

  1. It helps in financial planningFinancial PlanningFinancial planning is a structured approach to understanding your current and future financial goals and then taking the necessary measures to accomplish them. Because this does not begin and end in a specific time frame, it is referred to as an ongoing process.read more for the domestic governments.
  2. Help protect the competitive level of the exported goods from the domestic country to foreign currency.
  3. It further helps in the easy purchase of critical commodities such as food products and oils as the domestic country has pegged itself to the most popular foreign currency.
  4. It helps in the stabilization of monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more.
  5. Reduces the volatility present in the foreign financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more as it helps the domestic business predict the costs and exact pricing of the commodities.
  6. Supports the increase in living standards and the continued growth in the domestic economy.

Disadvantages

  1. There is an increased intervention of foreign affairs with domestic affairs.
  2. The central bank has to constantly monitor the demand and supply of foreign currency concerning its domestic currency.
  3. The currency pegs don’t allow adjustments to the deficits in the accounts automatically.
  4. Promotes disequilibrium as there are no real-time adjustments in the capital accountsCapital AccountsThe capital account refers to the general ledger that records the transactions related to owners funds, i.e. their contributions earnings earned by the business till date after reduction of any distributions such as dividends. It is reported in the balance sheet under the equity side as “shareholders’ equity.”read more for domestic and foreign countries.
  5. It can give rise to speculative attacks on the currency’s value if they are not in line with the value of the fixed exchange rateFixed Exchange RateA fixed exchange rate refers to an exchange rate regime where a country’s currency value will be tied with the value of another country’s currency or a major commodity.read more.
  6. The speculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more push domestic currencies from their fundamental value and easily enforce their devaluation.
  7. To sustain currency pegs, the domestic countries maintain huge foreign reserves, which further employ high capital usage, giving rise to inflation.

Limitations

Important Points

Conclusion

Currency pegs help in promoting stability between the trading entities. Its role is critical for comprehensive forex trading, which displays volatility at periodic intervals. In such a system, the domestic country pegs their currencies with gold or other known and most used foreign currencies such as dollars or euros.

Frequently Asked Questions (FAQs)

1. Is currency pegging good? 

The impact of currency pegging depends on various factors and circumstances. Currency pegging can provide stability in international trade, attract foreign investments, and help control inflation. However, it can also limit monetary policy flexibility, restrict the ability to respond to economic shocks, and potentially lead to speculative attacks. The effectiveness and desirability of currency pegging vary based on a country’s specific economic conditions and policy objectives.

2. What country has a pegged currency?

Several countries have pegged their currency to another currency or a basket of currencies. Examples of countries with pegged currencies include Saudi Arabia (pegged to the US dollar), Hong Kong (pegged to the US dollar), and the United Arab Emirates (pegged to the International Monetary Fund’s Special Drawing Rights).

3. What are the risks associated with currency pegging? 

Risks associated with currency pegging include vulnerability to external economic conditions, loss of competitiveness in international markets, potential for speculative attacks, and limited ability to pursue independent monetary policy. Maintaining the peg may require significant foreign currency reserves in case of economic shocks. 

This has been a guide to what currency peg is and its meaning. Here we discuss the components of currency peg and its formula and examples. You can learn more about financing from the following articles –