Currency peg definition
/What is a Currency Peg?
A currency peg is used by a national government to define a fixed rate at which its currency will trade. Doing so provides a stable exchange rate between that currency and other currencies, which provides stability to ongoing business transactions via a reduced level of foreign exchange risk. Currency pegs are normally established between a national currency and the U.S. Dollar or the Euro, and may not change for many years.
Advantages of a Currency Peg
A currency peg is especially important for lower-margin businesses that cannot afford to pay for foreign currency hedges, and cannot absorb losses from unexpected swings in the exchange rate. With a high degree of exchange rate stabilization in place, it is more likely that trading volume will increase, since the risk of doing so is reduced. In addition, it tends to foster more stable supply chains, since buyers and sellers do not have to worry about exchange rate fluctuations cutting into their profits.
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Disadvantages of a Currency Peg
There are several problems with a currency peg, as noted below.
Cost of Maintaining the Peg
A currency peg can be difficult and expensive to maintain, especially if the selected fixed rate is substantially different from the rate at which the currency would normally trade, based on supply and demand. Also, a country’s central bank will need to hold substantial foreign exchange reserves in order to buy its currency whenever there is weak demand for the currency (which would otherwise drive down the exchange rate). This can result in the loss of all foreign exchange reserves, triggering the collapse of the peg and turbulence in the foreign exchange market.
Possibility of Economic Manipulation
When an exchange rate is set too low, it increases the cost of imports for a country’s citizens, thereby encouraging them to buy locally at the expense of foreign sellers. This tends to cause trade tensions between countries. An aggrieved country might then take the same action with its currency peg, resulting in a rapid decline in international trade.