Currency Peg: Meaning, How it Works, Types, and Examples

A currency peg is a policy by which governments and central banks fix the exchange rate of their domestic currency by tying it to a stronger foreign currency, gold, or a basket of currencies.

Currency pegs are very popular among small and developing countries. They help reduce exchange rate volatility and stabilize their currency, making the countries attractive to international businesses and investors.

Sixty-six countries, including China, have tied their currencies to the stable U.S. dollar (Dollar peg), and another 25 countries have tied their currencies to the Euro (Euro peg).

What is a Currency Peg?

A currency peg is a fixed exchange rate system implemented by a government or central bank to stabilize the value of its domestic currency by tying it to another country’s currency, a basket of currencies, or gold, as part of monetary policy.

Countries peg their local currencies to more stable foreign currencies or commodities like gold, hoping to avoid wild exchange rate fluctuations that make doing business with other countries difficult.

The alternative to a currency peg is a free-floating model, in which a currency’s value and rate are subject to the market’s supply and demand forces.

Understanding the difference between a free-floating currency and a pegged currency is important for novice traders as they learn forex trading terms. Pegging a currency affects the currency’s volatility, reducing the number of opportunities a trader has in the market.

What does Pegging Currency mean?

Pegging currency means tying or linking one country’s currency to another, typically a stronger or more stable one. Once affected, the domestic currency can only fluctuate in a range usually between -1% to +1% against the benchmark currency.

Central banks that utilize currency pegging policy frequently intervene in the forex market (manipulation) when their currency faces huge volatility, ensuring that the peg remains at the predetermined exchange rates.

Are Currency Pegs and Fixed Exchange Rates the same?

No, but there are very similar concepts.

A currency peg is a specific fixed exchange rate system used by governments through central banks to link the local currency to a foreign currency, basket of currencies, or gold.

A fixed exchange rate, on the other hand, refers to various systems that governments use to fix or stabilize their currency’s value. It includes currency pegs but covers other systems like currency boards and monetary unions.

What is the purpose of Currency Peg?

The main purpose of a currency peg is to stabilize the exchange rate of a domestic currency by preventing wild price fluctuations. Stabilizing the exchange rate is vital for countries that rely on international trade and investments as it makes it easier for investors and businesses to predict and manage their foreign exchange risks.

Countries turn to currency pegs to artificially cheapen their goods, thereby increasing the competitiveness of their exports in the global market.

Currency pegs are important for ensuring a stable and predictable currency exchange rate, boosting local exports, and indirectly taming inflation.

Why is it important to Peg a Currency?

Pegging a currency to a more stable currency or a developed economy is important because it reduces the foreign exchange risks involved in conducting business between countries.

For small economies and developing nations, pegging their currency to that of a developed nation allows them to advance at a relatively similar speed compared to foreign countries. For instance, countries with currencies pegged to the U.S. Dollar (the world’s reserve currency) enjoy smoother international trade and investment flow because, according to the Bank of International Settlements, nearly 90% of the world’s foreign exchange transactions are conducted in U.S. dollars.

Most oil-reliant Middle Eastern countries, such as Qatar, the United Arab Emirates, Oman, and Saudi Arabia, peg their currencies to the dollar.

Financial hubs in Asia, like Hong Kong, Macau, and previously China, peg their currencies to the USD because they oversee a lot of business in dollars. The same is true in economies that depend on U.S. tourism and trade, such as the Caribbean countries of the Bahamas and Barbados. The lower currency value of these countries, compared to the dollar, enables them to manufacture goods at cheaper prices. By pegging their currencies, they gain access to a huge export market at competitive rates in the U.S. and other big countries like China.

Currency pegs only work if done between countries that conduct many trade transactions with each other.

How does Currency Peg work?

In practice, a currency peg works like a strategic partnership where one government ties its currency in a predetermined ratio to another country’s currency or a specific basket of currencies.

The central bank with a weaker currency compares and chooses a specific exchange rate or a range of permitted exchange rates for their currency against a stronger currency like the USD, Euro, or gold, then announces that new rate policy to the public.

If market forces like supply and demand or political and economic events push the currency’s value higher or lower past the determined exchange rates, the central bank intervenes by selling or buying its currency, respectively, to balance the volatility and maintain the peg.

Central bank interventions work as long as the country has enough dollars in its reserve. Once the dollar reserve levels run below acceptable levels, the currency is ‘depegged’ and allowed to float in the open market until it finds its real value.

In instances when market participants test the central bank’s resolve to maintain a fixed peg by betting against it, the bank has to demonstrate its commitment to that policy. An example of the determination to conduct a currency pegging policy happens in China, where the government implements a strict capital control policy that makes it illegal to transact their currency at any rate other than the pegged rate. The strict capital control policy has, however, led to the rise of illegal black-market transactions as people try to bypass the currency peg in the open forex market.

How does Currency Peg work in the Forex Market?

A currency peg in the forex market works through a country’s central bank, fixing the exchange rate of its domestic currency to that of another stable currency or basket of currencies.

For example, if a country pegs its currency to the U.S. dollar at 1:2, then two units of the domestic currency will always be exchanged for one U.S. dollar. The fixed exchange rate hugely affects the forex exchange market, the marketplace where commercial banks, big financial institutions, and individuals trade currencies against each other.

The most basic form of forex exchange is converting money to another currency when traveling to another country. If an American flies to London and exchanges his Dollars for British Pounds at the airport, that transaction forms part of the forex market.

For a pegged currency, the central bank strives to maintain that peg ratio and intervenes if the forex exchange rate deviates from that peg rate. Central bank intervention ensures price predictability for the domestic currency and limits the forex exchange rate fluctuations, which is good for traders and investors.

Does Currency Peg Affect Exchange Rate?

Yes. Currency pegs affect the exchange rate by reducing a currency’s volatility. As the central bank intervenes by buying and selling the currency to counter speculation and maintain the peg, they limit price discovery through normal supply and demand. The pegged exchange rate is often manipulated and not the real market value of that currency.

What are the different Types of Currency Pegs?

The different types of currency pegs are listed below.

1. Crawling Peg: A crawling peg is a currency peg that allows central banks to adjust the fixed exchange rate periodically, usually in small increments, at predetermined intervals. The periodic adjustment ensures the domestic currency has some flexibility in responding to economic conditions while maintaining a relatively stable exchange rate. An example of a currency using a crawling peg is the Vietnamese Dong.
2. Soft Peg: A soft peg is a currency peg where the central bank allows the exchange rate to float within a narrow band around a central rate. Allowing the exchange rate to float within a narrow band means central banks only intervene when the rate strays too far outside the band. An example of a currency using a soft peg is the Chinese Renminbi (Yuan) since 1994.
3. Hard Peg: A hard peg is a currency peg where the central bank fixes the exchange rate at a specific rate. The fixed exchange rate remains constant, and the central bank intervenes heavily to maintain that exact rate. An example of a currency using a hard peg is the Saudi Arabian Riyal since 1986.
4. Basket Peg: A basket peg refers to a currency peg where a country’s exchange rate is fixed against a basket of currencies, typically the country’s major trading partners, and not one currency. Examples of basket peg currencies include the Chinese Renminbi (Yuan), the Kuwaiti Dinar, and the Singapore dollar (SGD).

What are Examples of Peg Currencies?

The examples of pegged currencies are listed below.

• The Chinese Renminbi (yuan) implemented a hard peg to the U.S. dollar between 1994 – 2005. Since then, China has adopted a soft-managed peg.
• The Saudi Riyal (SAR) has implemented a hard peg of 3.75 SAR to 1 USD since 1986.
• The United Arab Emirates Dirham (AED) was pegged to IMF’s Special Drawing Rights (SDR), a basket of currencies including the U.S. dollar, Euro, British Pound, Japanese Yen, and Chinese Yuan between 1980 – 2002. It is now pegged to the U.S. dollar at US$1 = AED 3.6725 since 2003.
• The West African CFA Franc (XOF) used in Senegal and Central African Franc (XAF) used in Cameroon and Chad is pegged to the Euro at a rate of €1 = F.CFA 655.957.
• The Kuwaiti Dinar is pegged to an undisclosed basket of currencies.
• The Bahraini Dinar is pegged to the U.S. dollar at a rate of 0.38 since 2018.
• The Hong Kong dollar is pegged to the U.S. dollar at a rate of 7.83 since 2020.

How to use Pegged Currency in Forex Trading?

The steps for using a pegged currency in forex trading are listed below.

1. Identify Pegged Currencies: Identify currencies pegged to another currency, such as the U.S. Dollar or a basket of currencies.
2. Understand the Peg: Understand the mechanism and stability of the currency peg. Research and keep track of the central bank’s monetary policy adjustments and interventions to determine whether the exchange rate is subject to periodic adjustments or managed within a narrow band.
3. Analyze fundamental factors: Monitor currency flows, balance of payments, and official statements from the central bank to assess the credibility of the peg and spot potential trading opportunities.
4. Consider market sentiment and speculation: Keep track of market sentiment and speculative activity related to the pegged currency. Market participants’ reactions to perceived risks or opportunities regarding the peg’s stability affect short-term price fluctuations.
5. Exploit routine fluctuations: Profit from short-term fluctuations in the pegged currency by employing a strategy that capitalizes on the frequent changes, which always revert to the official pegged rate.
6. Manage risk and exposure: Employ risk management strategies such as stop-loss orders, position sizing, and diversification while trading forex to protect against unforeseen fluctuations or disruptions in the pegged currency.

When to use Pegged Currencies in Trading?

Traders use pegged currencies in Forex trading when looking for repeating price fluctuations to exploit or when trying to identify crisis-prone economies.

Pegged currencies help traders spot and take advantage of price changes due to the low volatility in pegged currencies. Pegged currencies must revert to their pegged rates, making it easy to predict and exploit temporary mispricings for profit.

Traders analyze pegged currencies to identify countries facing a currency crisis due to economic or political instability. By analyzing different pegged currencies, they can open long-term positions that require the peg to be tested or broken.

It is, however, important to note that using pegged currencies has advantages and disadvantages.

What are the Advantages of Pegged Currencies?

The advantages of pegged currencies are listed below.

• Stability in exchange rates: Pegged currencies reduce exchange rate volatility, making it easy for domestic business to calculate their exact costs.
• Lower currency risk: Pegged currencies gain access to deep liquidity, e.g., from the U.S. dollar market, allowing them to avoid currency crises during economic uncertainty.
• Promotion of price stability: Pegged currencies often align their monetary policies with those of the currency they are pegged to. Aligning monetary policies builds policy discipline and promotes macroeconomic stability.
• Facilitation of international trade: Pegged currencies ensure a stable exchange rate, which makes it easier for businesses to engage in cross-border transactions.
• Attracting foreign investment: Currencies pegged to a stable currency like the USD enhance confidence among international trading partners and investors, leading to increased trade volumes and foreign investment.

What are the Disadvantages of Pegged Currencies?

The 5 biggest disadvantages of pegged currencies are listed below.

• Loss of monetary policy autonomy: Pegged currencies limit a country’s ability to pursue independent monetary policies tailored to domestic economic conditions, as they cannot simply print more money to stimulate their economy.
• Speculative attacks: Pegged currencies attract speculative activities by traders and investors betting on potential deviations from the pegged exchange rate. Speculative activities create instability in the foreign exchange market.
• Misallocation of resources: Pegged currencies often produce distorted price signals when the currency is overvalued or undervalued, leading to reduced trade competitiveness and inefficient allocation of resources across sectors.
• Limited flexibility in economic adjustments: Pegged currencies limit a country’s ability to respond to external economic shocks, such as economic downturns in the country whose currency it is pegged to.
• Pressure on foreign reserves: Maintaining a pegged currency is costly and can strain foreign currency reserves in small and developing countries.

Is Pegging Currency bad?

No, pegging a currency is beneficial in the short term for countries looking to stabilize their exchange rate and spur economic growth by boosting their exports.

Pegging Currencies becomes a problem for countries looking to adapt to changing economic conditions and enhance their long-term growth. Currency pegging is bad or good depending on each country’s unique economic context and long-term policy objective.