Pegging

What are currency pegs?

A peg is tying one currency’s exchange rate to another. The normal practice in most countries is to peg their currency’s exchange rate to that of the US dollar. Some countries tie their currencies to currency baskets. This means that a currency’s exchange rate is linked to the exchange rates of a group of other currencies. 

Using pegs means purchasing or selling a large quantity of securities to influence its price. A government may do this to stabilise the price of securities or underlying assets. Companies or individuals can also do it unethically to drive prices in one direction or another for the benefit of option writers. 

How is it done? 

It is the process of connecting or linking a currency’s exchange rate to another country’s currency; and frequently involves predetermined ratios, which is why it is referred to as a fixed rate. Pegs are frequently used to bring stability to a country’s currency by connecting it to another stable currency. 

Many countries stabilise their currencies by pegging them to the US dollar, which is often regarded as the most stable currency in the world. Currency pegs can promote trade and raise real incomes, but they can also lead to persistent trade deficits. 

Pegging is also an unlawful tactic used by certain purchasers and writers (sellers) of call and puts options to influence the price.

Benefits 

Currency depreciation risks are eliminated when a currency is pegged to a stronger currency. 

Another benefit is low inflation. When a country’s currency is pegged to the US dollar, it experiences low inflation because the dollar’s value is higher than the value of other currencies. Pegging allows a country to import low-cost goods while reducing import inflation. 

A country with a fixed currency may always expand its money supply. But a country that expands its money supply will need to keep an eye on inflation. 

Currency pegs 

Currency pegs are policies in which a national government or central bank establishes a fixed exchange rate for its currency against a foreign currency or a basket of currencies to stabilse the exchange rate between countries. 

The currency exchange rate represents the value of one currency concerning another. While some currencies are free-floating, with rates fluctuating according to market supply and demand, others are fixed and pegged to another currency. 

The primary reason for a currency peg is to encourage international trade by lowering foreign exchange risk. Countries frequently establish a currency peg with a stronger or more developed economy for domestic firms to access broader markets with less risk. 

Advantages 

• It aids domestic governments in their financial planning. 
• Assist in preserving the competitiveness of domestic goods exported to foreign currencies. 
• It also facilitates purchasing key commodities like food and energy because the native currency is tied to the most popular foreign currency. 
• It contributes to the stabilisation of monetary policy. 
• Reduces the volatility in the foreign financial markets by assisting domestic businesses in predicting the costs and exact pricing of commodities. 
• Supports the rise in living standards and the domestic economy’s continued expansion. 

Disadvantages 

• Foreign policy increasingly interferes with internal concerns. 
• The central bank must continually monitor foreign currency demand and supply concerning its home currency. 
• Currency pegs do not allow for automatic corrections to account for deficits. 
• As there are no real-time changes in capital accounts for home and foreign nations, it promotes disequilibrium. 
• It can lead to speculative attacks on the currency’s value if it deviates from the value of the fixed exchange rate. 
• Domestic currencies are pushed away from their intrinsic value by speculators, who readily enforce depreciation. 
• Domestic nations retain massive foreign reserves to preserve currency pegs, which leads to excessive capital consumption and inflation. 

Frequently Asked Questions