What it means
Most major currencies float, meaning their value moves with supply and demand in the market. A pegged currency is different, because the authorities announce a target rate and commit to defending it.
For example, a country might fix its currency at 4 units to $1. To hold the peg, the central bank buys or sells its currency in the market.
If more people want to sell the local currency than buy it, the bank uses its foreign reserves to buy the local currency and support the price. If there is excess demand for the local currency, it sells local currency and builds up reserves.
The main benefit is stability. Importers, exporters and lenders can plan with a known exchange rate, and inflation can be easier to control if the currency is tied to a stable partner.
Small, trade-dependent economies and oil exporters often choose pegs for this reason. There are costs too.
To keep the rate fixed, the central bank must usually follow the interest rate policy of the country it is pegged to, even if its own economy needs something different. If investors doubt the peg can be held, they may rush to sell, draining reserves, and the central bank may be forced to devalue or abandon the peg.
There are several types of peg. A hard peg, such as a currency board, backs every unit of local currency with foreign reserves, whereas a soft peg allows the rate to move within a narrow band.
Some countries adjust the peg gradually, known as a crawling peg, to reflect differences in inflation. For companies, pegging changes how currency risk is managed.
A business selling into a pegged market faces little day-to-day exchange risk against the anchor currency, but still faces the tail risk of a sudden devaluation. Finance teams therefore monitor central bank reserves, current account balances and political signals as early-warning indicators.
In practice
Real-world examples.
Example
An oil-exporting country fixes its currency to the dollar because its oil sales are priced in dollars. The government can plan its budget with certainty about the exchange rate.
Example
A European exporter invoices customers in a pegged Middle Eastern currency. Because the rate is steady against the dollar, the finance team hedges only against the euro and dollar movement.
Example
A small island economy pegs its currency to a large neighbour. When the neighbour raises interest rates, the island must follow, even though its tourism industry is weak and needs lower rates.
Formula
Calculation
Local currency amount = Dollar amount x Peg rate
Reserves after defending the peg = Starting reserves - Dollars sold by the central bank
Suppose a fictional country, Zandar, pegs its currency at 4.00 zandars (ZND) per $1. An importer paying a $250,000 invoice needs 250,000 x 4.00 = ZND 1,000,000. Suppose investors rush to sell zandars, and the central bank must sell $2,000,000,000 of its $20,000,000,000 reserves to defend the rate. Reserves fall to 20,000,000,000 - 2,000,000,000 = $18,000,000,000, a drop of 2 / 20 = 10%. If the bank gave up the peg and the market rate moved to 5.00 ZND per $1, the same $250,000 invoice would cost ZND 1,250,000, which is 25% more (1,250,000 / 1,000,000 = 1.25).Case study
Seen in the real world.
Marlowe is an illustrative, fictional country that pegged its currency to the dollar at 10 marlows per $1 to calm inflation. For several years prices stayed steady, and local firms borrowed abroad in dollars because the exchange rate seemed safe.
When commodity prices fell, export income dropped and investors began selling marlows. The central bank spent $6,000,000,000, half its reserves, and then ran out of room and let the currency drop to 15 marlows per $1.
Companies with $100,000,000 of dollar debt saw the local cost of repayments rise from 1,000,000,000 marlows to 1,500,000,000, which is 50% more. The illustrative lesson is that a peg is only as strong as the reserves and policies behind it, and that borrowers should not treat it as risk free.
Watch out
Common mistakes.
- Treating a peg as a guarantee, when the central bank can run out of reserves and be forced to change the rate.
- Borrowing heavily in the anchor currency because the peg looks permanent, which creates a large loss if it breaks.
- Assuming a pegged currency cannot be devalued, when many pegs have been adjusted or abandoned.
Questions
People also ask.
Why do countries peg their currencies?
To create stability for trade and investment, and to import the inflation discipline of a stronger partner.
What is the difference between a peg and a float?
With a float, the market sets the exchange rate, while a peg is held at a target by the central bank.
What is a currency board?
It is a strict form of peg where every unit of local currency is backed by foreign reserves at the fixed rate.
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