Currency Pegging Explained: Benefits, Drawbacks, and Key Insights

What Is Currency Pegging?

Currency pegging is when a country fixes its exchange rate to another currency, often the U.S. dollar, to maintain economic stability. This approach helps reduce the risk of currency fluctuations, making international trade and investment more predictable. By keeping exchange rates stable, currency pegging can boost trade and investor confidence, especially for smaller or developing economies. But it can also create challenges, such as trade deficits or limited control over domestic monetary policy, because the peg may require constant market intervention and large foreign currency reserves.

How Currency Pegging Stabilizes Economies

Wide currency swings can harm international business, so many countries peg their currencies. Keeping their currencies stable removes a barrier to trade.

Pegging to the U.S. dollar is common, with over 66 countries doing so, says AvaTrade.

Benefits of Pegging a Currency

Currency risk is an issue for any company that imports or exports goods. For example, if a U.S. company operates in Brazil, the firm has to convert U.S. dollars into Brazilian reals (BRL) to fund its Brazilian business. If the value of Brazil’s currency changes dramatically compared to the dollar, the U.S. company may incur a loss when it converts back into U.S. dollars.

A nation with a pegged currency gains an edge in international trade.

Exchange rates between pegged currencies are not necessarily 1/1. For instance, the fixed rate for a U.S. dollar is 3.67 United Arab Emirates dirham (AED).

A country's central bank  trades its currency in the open market to keep the peg stable.

Pros and Cons of Currency Pegging

Nations should weigh the pros and cons before deciding to peg their currency.

Advantages of Currency Pegging

Pegging a currency can expand trade opportunities and boost citizens' real incomes by reducing fluctuations. Individuals, businesses, and nations are free to benefit more fully from specialization and sell their goods in other countries without the associated exchange rate risk.

According to the theory of comparative advantage, everyone will be able to spend more time doing what they do best. Farmers can concentrate on their crops rather than spending time and money hedging foreign exchange risk with derivatives. Technology firms can focus on building better computers.

Importantly, retailers can buy from the most efficient producers in both countries. Pegged exchange rates make more long-term investments possible in the other country. A currency peg stabilizes exchange rates, preventing supply chains disruptions and investment value changes.

Disadvantages and Risks of Currency Pegging

Countries can experience problems when a currency is pegged at low exchange rates. Domestic consumers lose purchasing power for foreign goods.

For example, the Chinese yuan is pegged against a basket of foreign currencies. If its peg is too low against the U.S. dollar, Chinese consumers will have to pay more for imported food and oil, lowering their consumption levels and their standard of living. At the same time, U.S. farmers and Middle East oil producers will lose business. This situation naturally creates trade tensions.

More issues arise when a currency is pegged too high. A country may be unable to defend the peg over time. Domestic consumers will buy too many imports and consume more than they can produce. These chronic trade deficits will create downward pressure on the home currency, and the government will have to spend foreign exchange reserves to defend the peg. Eventually, reserves can deplete, leading to a peg collapse.

When a peg collapses, countries with high pegs face pricier imports. That will cause inflation to rise, and the nation may have difficulty paying its debts. The other country will find its exporters losing markets, and its investors losing money on foreign assets that are no longer worth as much in domestic currency.

Reasons for Pegging Currencies to the U.S. Dollar

When a country pegs its currency to the dollar, it fixes the exchange at a set, predetermined rate. The value of the currency is maintained by the country's central bank.

Since the U.S. dollar's value is on a floating rate, it fluctuates. This means that the pegged currency's value rises and drops with the dollar.

Countries that peg their currency to the dollar do so because the U.S. dollar is relatively strong and relatively stable in the international market. As the world's reserve currency, international trade often is paid in U.S. dollars. This helps keep a country's pegged currency stable.

Some countries peg to the dollar because it helps keep their currencies and, therefore, their exports priced competitively. Others. such as Singapore and Malaysia, do so because their economies are particularly reliant on trade.

Notable Currencies Pegged to the U.S. Dollar

At least 66 nations have tied their currencies to the U.S. dollar.

Aside from the dollar's stability, some nations have additional reasons related to their economic strengths. For example, many Caribbean island nations including Aruba, Barbados, and Bermuda, rely on American tourists who are paying in dollars.

Notable countries with currencies pegged to the dollar include:

• Belize dollar (BZ$): 2.00
• Cuba convertible peso (CUC): 1.000
• Hong Kong dollar (HKD): 7.76
• Panama balboa (PAB): 1.000
• Saudi Arabia riyal (SAR): 3.75
• United Arab Emirates dirham (AED): 3.673
  

The Bottom Line

Countries use currency pegging to stabilize their currency and strengthen trade by linking their exchange rate to a more stable currency, most commonly the U.S. dollar. This helps reduce currency risk in international transactions and can attract foreign investment by providing greater predictability. There are risks associated with pegging, as central banks must constantly intervene to maintain the fixed rate, which can strain economic resources. Poorly managed pegs may lead to issues like trade deficits, inflation, and declining purchasing power. While pegging offers stability and trade advantages, it also limits monetary flexibility, making it important for policymakers to balance its benefits and drawbacks within their broader economic goals.