Around 70 currencies are pegged to the U.S. dollar, including the United Arab Emirates (UAE) dirham and Saudi Arabia riyal. Currency pegging refers to a practice that involves a country attaching (or pegging) its exchange rate to another country’s currency. But what is the purpose of pegging? What are its pros and cons? This article will answer all these.
What is currency pegging?
Currency pegging happens when a government sets an exchange rate between the country’s domestic currency and a foreign one. Because it involves a predetermined ratio, pegging is also called a fixed exchange rate.
In the monetary world, there are two types of exchange rates. A floating exchange rate is determined by market supply and demand. The value of floating currencies like the U.S. dollar and euro changes depending on how they fare on foreign exchange markets. On the other hand, fixed currencies are set — and maintained — at a specific exchange rate to a foreign currency.
Pegging or having a fixed exchange rate aims to bring stability, mitigating the impact of market volatility.
The advantages of currency pegging
Here are the pros of pegging a domestic currency to a foreign one.
- It supports a stable environment. With pegging, a government attempts to create a more predictable environment for trade and investment. Fluctuating exchange rates or currency volatility will not substantially impact the value of investments, making it more efficient for businesses and investors to make and implement long-term plans.
- It aids in inflation control. As emphasized by the International Monetary Fund (IMF), “Pegging the exchange rate can lower inflation by inducing greater policy discipline and instilling greater confidence in the currency.” When a country does currency pegging, it means that the government will have a stricter management of currency supply and demand to keep the exchange rate stable. This prevents the country’s central bank from engaging in loose monetary and fiscal policies (such as government overspending and excessive money printing) that can fuel inflation.
- It fosters competitiveness. If currency fluctuations are relatively low, pegging can boost real incomes and expand trade. Pegged exchange rates can keep export prices competitive, and market players can specialize better because of minimal exchange rate risk. By focusing on core activities, several sectors can drive their businesses forward. For example, farmers can concentrate on optimizing their food production without engaging in complex foreign exchange hedging strategies. Meanwhile, retailers can maintain efficient supply chains and source from the most cost-effective producers globally, enhancing the variety and affordability of goods available to consumers.
The disadvantages of currency pegging
While pegging brings significant advantages, it also has its share of cons.
- It reduces monetary policy independence. To some degree, a government that implements a fixed exchange rate can experience a loss of monetary policy independence. Instead of prioritizing policies tailored to the country’s specific economic conditions, the primary focus is maintaining the peg. The country’s central bank must also thoroughly monitor and manage cash flow to prevent any spikes in the supply and demand of the domestic currency. Moreover, to maintain the peg, a country must have substantial reserves of foreign currency, which can rather be costly.
- It could deprive consumers of purchasing power. If the domestic currency is pegged at an excessively low exchange rate, it can lower the local consumers’ capacity to buy foreign goods. Now, on the other hand, if the exchange rate is overly high, it can drive the purchasing power upward and increase imports. This can lead to chronic trade deficits, which, in turn, can negatively affect the home currency. The government will be forced to spend its foreign exchange reserves to maintain the peg.
Final thoughts
For countries wanting to stabilize their economies, currency pegging is a monetary tool that can prove to be effective. By attaching the home currency’s value to a foreign one, it minimizes currency volatilities and introduces other advantages. These include better competition and minimized inflation.
Like other monetary policies, pegging has its own set of disadvantages. The key is to strike a careful balance and monitor market conditions so that a government can make adjustments that align with the country’s broader economic goals.
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