The Economics of Currency Pegs: Stability vs. Risk

A currency peg is a policy in which a country’s government or central bank fixes the exchange rate of its currency to the value of another currency or a basket of currencies. The pegged rate is enforced by the country’s central bank, which will exchange currency at that rate.

Commonly, countries that participate in this practice prefer to peg their currency to the US dollar, as it is seen as a stable currency globally. There are also a few examples of a Euro peg, including the Danish krona, which made the decision not to adopt the Euro as its currency. Currency pegs can be temporary or long-term; for example, the CHF (Swiss franc) was pegged to the Euro between 2011-15.

Another well-known and often-discussed example of a currency peg is the connection between the Hong Kong Dollar (HKD) and the US Dollar (USD). Since 1983, the Hong Kong Monetary Authority (HKMA) has maintained a peg, allowing the HKD to trade within a narrow range of 7.75 to 7.85 to the USD. The HKMA commits to buying or selling HKD at this range to maintain the peg.

Implications of currency pegs.

There are potential challenges as well as the perceived advantages associated with currency pegs, These include:

1. Stability:
   • For the Pegging Country: A currency peg can provide stability to a country’s currency, especially if it’s pegged to a stable currency like the USD. This can help reduce inflation and foster a predictable trading environment.
   • For Global Trading Partners: Businesses and investors in both the pegging country and its trading partners may enjoy reduced currency risk.
2. Interest Rate Impact:
   • Alignment with Pegged Currency: The interest rates in the pegging country often have to align with those of the currency to which it is pegged, which may impact the respective central bank’s ability to conduct independent monetary policy.
3. Foreign Exchange Reserves:
   • Need for Ample Reserves: Maintaining a peg requires the central bank to have substantial foreign exchange reserves to buy or sell its currency as needed to retain its value within the range of any currency peg.
4. Potential for Currency Speculation:
   • Vulnerability to Attacks: If traders believe that the peg is unsustainable, they might bet against it, leading to potential financial crises if the central bank’s reserves are depleted.
   • Limited Trading Opportunities: A peg can mean less volatility and fewer opportunities to profit from large swings in the currency’s value for traders.
5. Effects on Trade Balance:
   • Competitive Advantage or Disadvantage: A peg might make a country’s exports more competitive (if pegged low) or less competitive (if pegged high), impacting trade balances.
6. Potential for Economic Misalignment:
   • There may be challenges in adjusting to major economic events as a peg might prevent a currency from adjusting to economic changes locally or globally,  potentially exacerbating economic downturns or bubbles.

Summary

A currency peg is a significant monetary tool that can bring stability but also comes with trade-offs and potential risks. It can affect everything from inflation to interest rates, trade balances, and investor behaviour. For traders, pegged currencies may limit opportunities compared to those of the general foreign exchange market pairs.