Currency Peg

Currency Peg Meaning

A currency peg is defined as the policy wherein 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.

Components of Currency Peg

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#1 – Domestic Currency

This 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. This is the primary currency that may be used for the instrument of exchange within the border of the country.

#2 – Foreign Currency

This is a legal and acceptable tender having value outside the borders of the country.  It may be kept by the domestic country for the purpose of monetary exchange and recordkeeping.

#3 – Fixed Exchange Rate

This is defined as the exchange rate that is fixed between two countries to supplement the trade between two countries. In such a system, the central bank aligns its domestic currency with the currency of the other country.  It helps the exchange rate to be maintained at an acceptable and narrow area.

Currency Peg Formula

It is computed using the relationship as described below: –

Here,

• The domestic currency is represented by Dom.
• The generic notations are represented by Xi, Xm.
• The time period is represented as t.
• The foreign currency is represented by i.

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 value of gold increased or decreased, so was the relative effect on the currency of the domestic country which had pegged its currency to gold. The US had huge reserves of gold and therefore added to their advantage when USA pegged US dollars with the gold.

It also helped them to establish strong international tradeInternational TradeThe trading or exchange of products and/or services across international borders is referred to as international trade. It frequently includes other risk factors such as exchange rate, government policies, economy, laws of the other nation, judicial system, and financial markets that impact trade between the two.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 the period of 2015, China broke the peg and separated itself with the US dollars.
• It later established its peg with the currency baskets of 13 countries.
• The basket of currencies, allowed China to had competitive trade relations.
• The export of china became strong with those countries which had relatively weaker currency than that of the Chinese currency Yuan.
• However, there were certain types of business in the United States that gained or thrived due to a weaker Chinese currency Yuan.
• However, in the period of 2016, it re-established the peg with the US dollars.

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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 in protecting 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 to predict the costs and exact pricing of the commodities.
6. Supports the increase in the standards of living 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 with respect to 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 value of the currency if they are not in line with the value of the fixed exchange rate.
6. The speculators push domestic currencies from its fundamental value and hence easily enforce its devaluation.
7. To sustain currency pegs, the domestic countries maintain huge foreign reserves which in turn further employs high usage of capital, and hence such a situation gives rise to inflation.

Limitations

• The central bank maintains reserves of foreign reserves which helps them in easy buy or sell reserves at a fixed rate of exchange.
• If the domestic country ran out of the foreign reserves that have to maintain then currency peg no longer is considered to be valid.
• This further leads to Currency devaluationCurrency DevaluationCurrency devaluation is deliberately done in order to adjust the established exchange rates by the government and it is mostly done in the cases of fixed currencies. This mechanism is used by economies with a semi-fixed or fixed exchange rate, and it should not be confused with depreciation.read more and the exchange rate is free to float.

Important Points

• The currency pegs came into limelight after the period of Bretton Woods.
• By pegging the domestic currency with foreign currency, the domestic countries attempt to move at a similar speed as compared with the foreign country.
• The central bank of the domestic country may maintain a peg in such a fashion that the that it may buy foreign currency at one rate and sell foreign currency at other currency.
• It helps the importers to do business effectively since the currency exchange is pegged at a fixed rate.
• The most popular foreign currency to which domestic countries pegs the exchange rate is dollars.
• The gold is the most popular commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more on which domestic countries pegs their fixed exchange rate.
• It tends to provide a necessary cushion for its domestic economic interests.

Conclusion

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

Recommended Articles

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

• Currency Market
• Currency Depreciation Definition
• Currency Devaluation Examples
• Exchange Rate Risk