Currency Peg Explained: The Differences Between Traditional and Pegged Currency
The currency exchange rate dictates the value at which two currencies can be exchanged. You can see these rates every time you go to an exchange to buy foreign currency: one dollar equals 0.95 euro, 1.63 Canadian dollars, or 111.05 Serbian dinars, and so on. So, we could also say that these numbers dictate how much of your domestic currency you need to provide to buy a specific amount of foreign money.
Currency peg refers to the policy utilized by central banks or governments to maintain a fixed exchange rate for another country’s currency. In other words, a currency peg is when an authorized body ties currency accepted as legal tender to a foreign fiat currency in hopes of stabilizing the exchange rate policy between the two parties, in this case – the two (occasionally more) countries, involved.
Yet not all currencies are pegged currencies. As a matter of fact, most governments employ a free-floating exchange rate system, which is the complete opposite of a currency peg. One of the primary differences between the two is that a free-floating exchange rate system allows governments to bypass central banks as bodies of influence over exchange rates. As a result, the market’s supply and demand dictate the value differences between local and foreign currencies, keeping them in check.
What Is the Point of a Currency Peg?
You’re not alone if you’re wondering why some countries peg their local currency to foreign money. So, let’s see what the primary motivators for a currency peg are.
For starters, a stable exchange rate between countries can encourage trade, bringing prosperity to both. The currency peg ensures stable rates and mitigates the risk of monetary losses due to unpredictable and sometimes devastating fluctuations.
Governments will initiate a currency peg with an economically stronger state to avoid losses and establish a stable ground for financial planning within the country. Once established, a fixed exchange rate will encourage a favorable economic climate and boost money and capital flow security.
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The euro and the US dollar are the most common choices for establishing fixed exchange rate systems. These currencies are the most viable and popular options for a reason- they’re seen as relatively stable, and more importantly, euro and dollar are domestic currencies in prosperous countries that would make great trading partners.
Benefits of Pegged Exchange Rates
As stated earlier, governments turn to the fixed exchange rate regime to stabilize the economy and open new doors to safer, somewhat predictable trading. Although significant, these aren’t the only benefits of pegged exchange rates.
For example, governments could rely on this regime to not only predict but control the behavior of their local currency. Once pegged, currencies mitigate rates of inflation, as their value is now in tune with the value of the other currency. Of course, that doesn’t mean they’re equal. Instead, when a government adopts a pegged exchange rate system, the value of its pegged currency will fluctuate in relation to their predetermined reference values.
In other words, if the reference value rises or falls, the pegged currency rate will also rise or fall, preventing the value from plunging into the abyss. This could be beneficial to countries with highly volatile fiat currencies. But, as the terms of the pegged exchange rate system prevent a currency from plummeting, they also prevent it from reaching admirable heights, which could be seen as a significant advantage.
Still, fiat money isn’t as volatile as crypto, and “admirable heights” aren’t as drastic as fluctuations in the crypto market. Although it has its disadvantages, pegged exchange rate regime is sometimes far less risky than waiting for supply and demand to turn the market conditions in your favor and boost the value of the local currency.
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Another benefit of a fixed exchange rate system is that it makes international, as well as local, investments more feasible. Combined with minimal changes to the investment values due to market stability after the peg, the fixed exchange rate could be a recipe for a thriving and prosperous economy.
Disadvantages of Pegged Exchange Rates
While currency pegs could be a valuable tool in boosting the domestic economy, the fixed exchange rate system could also play a role in destroying it. For example, when pegged at a meager exchange rate, the pegged currency divests local customers of the purchasing power, preventing them from dabbling into foreign markets.
Conversely, a peg too high could increase inflation and even contribute to trade deficits. Pegged currencies could also disturb forex trading and pave a road for foreign bodies to meddle in local affairs.
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Once a country accepts the pegged exchange rate system, its central bank will maintain foreign reserves, allowing this body to trade at a fixed rate effortlessly. This is a limitation itself, mainly because a domestic country would lose the validity of its currency peg if it ran out of foreign reserves. Once that happens, the country has no choice but to return to the free-floating exchange rate regime, where market conditions dictate the exchange rate value.
Which Countries Have Pegged Their Currencies to Euro or US Dollar?
Some countries have been employing the fixed exchange rate system for decades, while others have just joined the club. That said, here are some examples of a successful switch from a free-floating exchange rate to a currency peg.
Countries such as Bahrain, Belize, Cuba, Saudi Arabia, United Arab Emirates, and Oman all have their currencies pegged to the US dollar. Some countries chose the dollar for stability, as they need the US as a partner for their oil business.
Although not as popular a choice as the dollar, the euro is in business, too. Bosnia and Herzegovina convertible mark, Comorian franc, Moroccan dirham, and Croatian kuna are some examples of currencies pegged to EUR.