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What Is a Currency Peg and How Does It Work?

Pegged exchange rate underlines the value of the national currency compared to the foreign one. A currency peg is a fixed exchange rate set by central banks or the government. Some countries have fluctuating rates and free-floating currencies. They are mainly based on the market supply and demand. Oppositely, other currencies are pegged to stronger ones offering a fixed exchange rate.

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The main benefit of pegging is the ability to provide transparency. Exchange rates are simpler to predict in the long-term perspective, which makes it easier to keep economic situations under control and promote nations’ financial health.

In this article, we will explain pegging currency meaning as well as discuss its major advantages and disadvantages. This will help Forex traders understand the market better.

Pegging Currency Meaning

The first and foremost reason to have a currency peg is to ensure efficient trading conditions between two nations. What’s more, the approach makes it possible to minimize foreign exchange rate risks.

As a rule, developing countries peg their currencies with developed nations featuring more advanced economies. As a result, domestic businesses and companies can benefit from broader market access with lower risks.

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Historically, USD, EUR, and gold have been the most popular options to have a pegged exchange rate. These assets make it possible to create stability between various countries and trading partners. As a rule, a currency peg can last for years or even decades. For instance, HKD has been pegged to USD since 1983. In the end, nations have a reliable instrument to make their monetary policy more effective.

Currency Peg Advantages and Disadvantages

To understand the potential of the pegging approach, about 25% of all countries in the world have their national currencies pegged to other major currencies. Most of all, they include the U.S. dollar and euro. As stated earlier, gold is also among the major options, although it is not for a particular nation.

The bad news is that a currency peg is hardly a perfect strategy. History has witnessed several examples of pegging exchange rates demolishing national economies. This is actually what happened to Argentina. Oppositely, some countries managed to gain success and strengthen their financial health, for example, China.

Pegging Exchange Rate Pros

As we said before, a currency peg has proved to be an effective way for developing countries to broaden their economic potential. Some nations have their national currencies pegged for decades. And there are some good reasons for that. The main advantages of pegging are as follows:

  • Steady Planning Basis. A currency peg creates a stable and healthy background for future economic planning. Nations always know how much they need to pay for different commodities including food and oil in a pegged asset. This fact makes financial structuring less hurtful and easier to predict. Of course, we should always take into account Forex market volatility. It can make commodity prices unbearable for developing countries with weaker economic health.
  • Well-Arranged Monetary Policy. Not surprising, currency pegs are mainly popular among third-world nations. Mainly, it refers to South America, Africa, and Asia with a high level of corruption. People in these nations do not trust their leaders and require a stronger backup in the face of a more powerful foreign asset as the main support for their economy. A currency peg helps to avoid hyperinflation.
  • Reduced Currency Volatility. All the above-mentioned advantages mainly refer to the government. However, we should also take into account some benefits for local businesses. With a pegging exchange rate, companies can easily predict the price of their goods and plan their budgets and financial campaigns accordingly. Besides, businesses know the exact quantity of products along with potential demand and revenues.

Pegging Exchange Rate Cons

The methodology is not perfect. We have seen many examples when companies with a currency peg were forced to announce bankruptcy. So, we always need to keep in mind the following currency peg downsides:

  • Growing Foreign Influence. The major drawback here is that weaker countries come with heavily influenced domestic affairs. In simpler words, foreign nations determine their monetary policy. We have observed dozens of conflict situations in the geopolitical arena featuring the attack on the British pound or the German Bundesbank increasing the interest rate to keep up with soaring inflation.
  • Difficult to Integrate. The pegging exchange rate is quite complex in automatic adjustment. The process can’t be integrated seamlessly into the nation’s financial structure, especially if the nation applies a floating currency system. Let’s say, a country imports too many goods. When it has its currency pegged, it will have to pay out a lot. As a result, the supply of the currency will decline to result in deflation.
  • Increasing Speculative Activity. In some cases, a just pegged currency can deviate from its value too much. The gap can be really huge, causing a growing number of speculative attacks. Besides, pegging exchange rates will create a large gap between the market and fundamental currency value. It will not happen in case of a floating exchange rate. It prevents deviating prices and instantly adjusts corrections.

Over the last decades, numerous financial funds have been founded to help weaker countries keep the situation under control after having their currencies pegged. Some of these funds have enough resources to take control over Central Banks. However, it does not protect nations’ economies from several speculative attacks. Sometimes, they have disastrous consequences making one country abandon the peg.

The Bottom Line

A currency peg is a fixed exchange rate that defines the value of one nation in connection with foreign currency. Mainly used by third-world countries with developing economies, pegging exchange rates can be a good instrument to strengthen the monetary policy and create new opportunities for local businesses. At the same time, it can lead to the country's bankruptcy and increased speculative attacks. The model will make sense for economies with a floating exchange rate.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.