Pegging

Currency Pegging

Currency pegging is the practice of fixing a nation’s exchange rate to another currency or a basket of currencies. Governments or central banks maintain the peg by buying and selling foreign exchange reserves to keep the domestic currency at a predetermined rate. Pegging is commonly used to reduce exchange-rate volatility, encourage trade and investment, and import the monetary credibility of a more stable currency.

How pegging stabilizes economies

• Reduces exchange-rate risk for businesses and investors, making cross-border trade and long-term contracts more predictable.
• Encourages foreign investment by providing a stable currency environment.
• Helps small or trade-dependent economies avoid disruptive currency swings that can harm supply chains and investment values.

Benefits

• Expands international trade and investment by eliminating exchange-rate uncertainty.
• Lowers the need for firms and individuals to hedge foreign-exchange exposure.
• Can raise real incomes and support specialization under comparative-advantage principles.
• Makes planning and long-term investment across borders easier by stabilizing prices in foreign trade.

Risks and drawbacks

• Loss of independent monetary policy: maintaining a peg often requires the central bank to prioritize the exchange rate over domestic goals like employment or inflation control.
• Vulnerability to mispricing: if the peg is set too low or too high relative to fundamentals, it can produce trade imbalances.
• A peg set too low can reduce domestic purchasing power for imports and create foreign trade tensions.
• A peg set too high can trigger persistent trade deficits and drain foreign-exchange reserves as authorities defend the peg.
• Peg collapses can lead to sharp import-price rises, accelerating inflation and making foreign debt servicing more difficult.
• Defending a peg can be costly and unsustainable if market pressures are strong.

Why many countries peg to the U.S. dollar

• The U.S. dollar is the dominant global reserve and invoicing currency, so tying a currency to the dollar helps stabilize international transactions.
• Pegging to the dollar can keep export prices competitive and reduce exchange-rate uncertainty for economies heavily reliant on trade.
• For tourism-dependent or dollar-inflow economies, a dollar peg simplifies transactions for visitors and businesses.

Examples of currencies pegged to the U.S. dollar

At least several dozen countries peg (or have arrangements linked) to the dollar. Examples include:
– Belize dollar (BZ$): 2.00 per USD
– Hong Kong dollar (HKD): ~7.76 per USD (currency board arrangement)
– Panama balboa (PAB): 1.00 per USD (uses the U.S. dollar domestically)
– Saudi riyal (SAR): 3.75 per USD
– United Arab Emirates dirham (AED): 3.673 per USD

Note: some listings change over time as countries adjust regimes; these examples illustrate common arrangements.

Special cases

• The Chinese yuan (renminbi) was pegged to the U.S. dollar from 1997–2005. Since 2005, China manages the yuan against a basket of currencies and sets a daily reference rate, rather than keeping a strict dollar peg.
• Some countries do not issue their own currency and instead use the U.S. dollar directly (dollarization). Examples include Ecuador, El Salvador, and others.

Soft peg vs. hard peg

• Hard peg: the government or monetary authority legally fixes the exchange rate and commits to maintain it (examples include currency boards or outright dollarization).
• Soft peg: the exchange rate floats within a managed band or the central bank intervenes occasionally to influence the rate without a rigid fixed parity.

Practical considerations for policymakers

• Maintaining a peg requires sufficient foreign-exchange reserves and credible policy commitment.
• Policymakers must weigh trade and investment benefits against the loss of monetary flexibility and the risk of speculative pressure.
• A peg works best when fiscal and structural policies align with the fixed-exchange-rate objective.

Summary

Currency pegging can provide stability, reduce transaction risk, and support trade and investment. However, it constrains monetary policy and can create vulnerabilities if the peg is misaligned with economic fundamentals. Successful pegging depends on prudent reserve management, consistent fiscal and economic policies, and realistic parity settings.