What happens when a currency peg breaks?

Pegging a currency creates an artificial exchange level, but one that is usually sustainable when done realistically. However, there is always a threat that markets, speculators, or currency traders could overwhelm the peg that was put in place. When this happens, it is known as a broken peg and the inability of a country to defend its currency from the broken peg can rapidly lead to devaluation of the currency and severe disruption to the local economy.

What are the real advantages of currency pegs?

There are a number of reasons why countries prefer to peg their currency to another. These reasons include enhanced stability for the pegged currency, increased trade and an increase in real income and profits for businesses. When exchange risk is removed from the economic equation both the pegging country and the country whose currency is used for the peg can benefit from enhanced specialization, trade, and exchange. Long-term investing also becomes more beneficial when a currency peg removes the threat of instability and economic disruptions.

What are the disadvantages of currency pegs?

The central bank of the pegging country must maintain a watchful eye on the supply and demand of their currency to ensure it doesn't get unbalanced. This means keeping adequate foreign currency reserves to counter any excessive buying or selling of the currency. Problems can also arise if the currency is pegged at a rate that is too low or too high. In the former case we see consumer purchasing power eroded, as well as trade tensions between the country with the artificially low exchange rate and its trade partners. In the latter case it may become increasingly difficult to defend the peg as excessive consumer spending will create trade deficits that create downward pressures on the pegged currency. This forces the central bank to spend foreign reserves to defend the peg and eventually these foreign reserves are exhausted, leading to a broken peg.

What is Currency Peg (Fixed Exchange Rate)?

What is Currency Peg?

Currency pegging is when a country attaches, or pegs, its exchange rate to another currency, or basket of currencies, or another measure of value, such as gold. Pegging is sometimes referred to as a fixed exchange rate.

A currency peg is primarily used to provide stability to a currency by attaching its value, in a predetermined ratio, to a different and more stable currency. As the world’s most widely held reserve currency, the US dollar (USD) is unsurprisingly the currency to which most currencies are pegged to.

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The US Dollar

Over 66 countries have their currencies pegged to the US dollar. For instance, most Caribbean nations, such as the Bahamas, Bermuda and Barbados, peg their currencies to the dollar because tourism, which is their main source of income, is mostly conducted in US dollars. This makes their economies stable and less prone to shocks.

In addition, oil producing nations, such as Oman, Saudi Arabia and Qatar, also peg their currencies to the US dollar for stability purposes; the United States is their major oil trading partner.

There are also countries that are heavily dependent on the financial sector, such as Hong Kong, Singapore and Malaysia; pegging their currencies to the US dollar provides them with the much-needed protection against the surprises and movements of the forex market.

Countries such as China that export most of their products to the United States, would want to peg their currencies to the US dollar to achieve or preserve competitive pricing.

By deliberately making and maintaining their currencies at a cheaper rate than the US dollar, their export products gain a comparative advantage in the American market.

In other instances, developing nations or countries with volatile economies, usually peg their currencies to the US dollar to guard against potential inflation.

Monitoring the Currency Peg

Since the US dollar also fluctuates, most countries usually peg their currencies to a dollar range as opposed to pegging to a practically fixed number. After pegging a currency, the central bank then monitors its value relative to the value of the US dollar.

If the currency rises above or falls below the peg, the central bank would use its monetary tools, such as buying or selling treasuries in the secondary market, to restore the peg.

Pros and Cons of Currency Pegs

Currency pegs have significant benefits. They provide a fundamental basis for government planning and also promote credibility and discipline in monetary policies, especially in the case of impoverished and unstable economies. With reduced volatility, businesses can also gain a competitive advantage in the international markets against rivals facing forex risk.

But currency pegs also come with associated cons. Countries that adopt currency pegs are naturally susceptible to foreign influence. As such, in cases of trade imbalances, there might be difficulty in attaining automatic exchange rate adjustments; and a minor deviation from the peg could invite heavy speculative attacks.

Still, it is financial crises that threaten the collapse or removal of currency pegs. For instance, there was a time when the British government pegged its currency to the German Deutsche mark.

The central bank of Germany, Bundesbank, increased its interest rates to curb domestic inflation. This was not the ideal situation for the British economy, which suffered greatly as a result of concerns in other jurisdictions. Nevertheless, currency pegs remain a handy financial tool that promotes fiscal responsibility, stability and transparency.

Stablecoins

With the many benefits of currency pegs, it is why the idea has managed to creep into the cryptocurrency world. Stablecoins are the most recent version of pegging in the crypto world.

A stablecoin is a cryptocurrency whose value is pegged to a real-world asset, such as a fiat currency. There are now over 50 projects in the crypto world that involve stablecoins.

Stablecoins perform an important function in an industry plagued by high price volatility; price swings of 5-10% daily are not uncommon in cryptocurrencies. Stablecoins offer the utility of easily converting crypto coins into fiat money. They are essentially an effort to provide the benefits of cryptocurrencies alongside the stability and trust of conventional fiat.

Going forward though, stablecoins would solve the liquidity problems of many crypto exchanges, while the technology could also pave the way for more financial services, such as loans and insurance, to be implemented in the crypto world.

Some examples of stablecoins include Tether and True USD which are pegged to the US dollar and bitCNY, which is pegged to the Chinese yuan (CNY).

Currency Peg main FAQs

What happens when a currency peg breaks?
Pegging a currency creates an artificial exchange level, but one that is usually sustainable when done realistically. However, there is always a threat that markets, speculators, or currency traders could overwhelm the peg that was put in place. When this happens, it is known as a broken peg and the inability of a country to defend its currency from the broken peg can rapidly lead to devaluation of the currency and severe disruption to the local economy.
What are the real advantages of currency pegs?
There are a number of reasons why countries prefer to peg their currency to another. These reasons include enhanced stability for the pegged currency, increased trade and an increase in real income and profits for businesses. When exchange risk is removed from the economic equation both the pegging country and the country whose currency is used for the peg can benefit from enhanced specialization, trade, and exchange. Long-term investing also becomes more beneficial when a currency peg removes the threat of instability and economic disruptions.
What are the disadvantages of currency pegs?
The central bank of the pegging country must maintain a watchful eye on the supply and demand of their currency to ensure it doesn’t get unbalanced. This means keeping adequate foreign currency reserves to counter any excessive buying or selling of the currency. Problems can also arise if the currency is pegged at a rate that is too low or too high. In the former case we see consumer purchasing power eroded, as well as trade tensions between the country with the artificially low exchange rate and its trade partners. In the latter case it may become increasingly difficult to defend the peg as excessive consumer spending will create trade deficits that create downward pressures on the pegged currency. This forces the central bank to spend foreign reserves to defend the peg and eventually these foreign reserves are exhausted, leading to a broken peg.

Final Words

Currency pegs play a significant role in forex trading and learning about them can also create arbitrage opportunities for traders. Learning more about the markets and understanding what impact market movements, will no doubt expand your capacity to take advantage of low risk but lucrative opportunities in forex trading. Join AvaTrade now and gain access to our comprehensive trading educational center and step into the trading arena with confidence.

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