In the foreign exchange (FX) market, supply and demand usually determine currency rates, which means that the market forces of buyers and sellers determine the value of a currency. As a result, the exchange rate will fluctuate according to changes in the respective countries' economic fundamentals. This system is known as a free-floating exchange rate system.
Dollar pegging refers to a system in which a country's currency is fixed to the US dollar at a predetermined exchange rate. Under this system, the country's central bank buys or sells its currency in the foreign exchange market to maintain the exchange rate within a specific range. As a result, if the value of the country's currency rises or falls against the US dollar, the central bank takes action to bring it back within the predetermined range.
Dollar pegging can take different forms, ranging from a hard peg to a soft peg.
A hard peg involves a fixed exchange rate with no flexibility, meaning that the central bank is committed to maintaining the exchange rate at the same level regardless of economic conditions. In contrast, a soft peg allows for some flexibility, with the exchange rate fluctuating within a specific range.
Dollar pegging can have both advantages and disadvantages for a country's economy. One of the main advantages is that it can provide greater stability and predictability in international trade and investment. A fixed exchange rate makes it easier for businesses to plan and make decisions regarding imports and exports and for investors to assess risks and opportunities.
However, dollar pegging can limit a country's ability to pursue independent monetary policy. A fixed exchange rate requires the central bank to maintain a certain level of foreign exchange reserves, which can restrict its ability to adjust interest rates and implement other monetary policy measures.
In addition, dollar pegging can also make a country's economy vulnerable to external shocks, such as changes in the global economic environment or sudden shifts in market sentiment. A dollar peg can lead to speculative attacks on the currency, which can be difficult to defend against.
A currency board is a monetary system in which a country's currency is pegged to another currency, typically the US dollar, at a fixed exchange rate. Unlike a traditional fixed exchange rate system, which involves a central bank buying and selling its currency to maintain the exchange rate, a currency board maintains a strict monetary rule that requires the central bank to hold foreign currency reserves equal to the amount of domestic currency in circulation.
Under a currency board system, the central bank issues new currency only when it has an equivalent amount of foreign currency reserves to back it up. Foreign currency reserves fully support the money supply, ensuring that the exchange rate remains fixed at the predetermined rate.
The main advantage of a currency board is that it provides a high degree of confidence and credibility in the monetary system. In addition, because foreign reserves fully back the currency, there is little risk of currency depreciation or devaluation, which can lead to hyperinflation and economic instability.
Currency boards are closely related to dollar pegging because they both involve fixing a country's currency to the US dollar. However, while a traditional fixed exchange rate system involves the central bank buying and selling its currency to maintain the exchange rate, a currency board relies on strict rules and regulations to maintain the fixed exchange rate.
Historical Dollar Pegs
The Bretton Woods Agreement
A global monetary agreement was signed in 1944 that established the US dollar as the world's reserve currency and fixed exchange rates to the US dollar. Under the agreement, countries could exchange their US dollars for gold at a fixed rate of $35 per ounce. However, in 1971, the US government ended the convertibility of the US dollar to gold, effectively ending the Bretton Woods system.
The Plaza Accord
An agreement was signed in 1985 between five major economies (the US, Japan, Germany, France, and the UK) to depreciate the US dollar to reduce the US trade deficit. The agreement resulted in a significant appreciation of the Japanese yen and German Deutsche Mark and a depreciation of the US dollar.
Contemporary Dollar Pegs
Hong Kong Dollar
The Hong Kong dollar has been pegged to the US dollar since 1983, with a fixed exchange rate of HKD 7.8 per USD. The Hong Kong Monetary Authority (HKMA) maintains the peg by buying and selling Hong Kong dollars in the foreign exchange market.
Saudi Arabian Riyal
The Saudi Arabian riyal has been pegged to the US dollar since 1986, with a fixed exchange rate of SAR 3.75 per USD. The Saudi Arabian Monetary Authority (SAMA) maintains the peg by buying and selling Saudi riyals in the foreign exchange market.
The Chinese yuan has been pegged to the US dollar in the past, but since 2005, the People's Bank of China (PBOC) has allowed the yuan to appreciate gradually against the US dollar. However, the PBOC maintains some control over the exchange rate by setting a daily reference rate for the yuan against the US dollar and intervening in the foreign exchange market to maintain stability.
Dollar pegging remains a popular monetary policy tool for some countries, particularly in minor emerging market economies. However, while dollar pegging can provide greater stability and predictability in the short term, it can also limit a country's flexibility in responding to changing economic conditions. As such, the choice between dollar pegging and a free-floating exchange rate system depends on a country's specific economic circumstances and policy objectives.
Effects of dollar pegging on FX trading
For FX traders, dollar pegging can create opportunities alongside significant risks. Accordingly, traders should be aware of the potential for sudden exchange rate changes and monitor economic and political developments that could impact the peg. If the situation worsens to the point where the peg is threatened to be abandoned or moved (re-pegged), the potential for a significant move in the exchange rate becomes much higher. In judging this threat, traders should monitor the impact of dollar pegging on the economy and financial markets, particularly in emerging market economies. Factors to watch out for could include:
Vulnerability to external shocks
Dollar pegging can make a country vulnerable to external shocks, such as changes in global interest rates, shifts in investor sentiment, or fluctuations in commodity prices. In addition, since the exchange rate is fixed, it may not reflect changes in the underlying economic conditions, which can create imbalances and lead to economic instability.
Limited monetary policy flexibility
Dollar pegging can limit a country's ability to pursue independent monetary policy. Since the exchange rate is fixed, a country's central bank may be unable to adjust interest rates or exchange rates to respond to changing economic conditions, making it more challenging to stabilize the economy or control inflation.
Potential for speculative attacks
Dollar pegging can create a risk of speculative attacks on the currency. For example, suppose investors believe the exchange rate is overvalued or unsustainable. In that case, they may sell the currency, which can create downward pressure on the exchange rate and make it more difficult for the central bank to maintain the peg. A classic example of this struggle was just before the UK left the Exchange Rate Mechanism of the then EEC (now EU) in 1992 when the now-famous investor George Soros heavily speculated that the pounds peg to the ECU basket of currencies would be abandoned, and sterling devalued.
The difficulty of maintaining a peg
Maintaining a peg can be challenging, particularly if significant economic imbalances or external conditions change rapidly. Central banks may need to intervene in the foreign exchange market to buy or sell currencies to maintain the peg, which can be costly and deplete the country's foreign exchange reserves. Also, maintaining a peg can create political pressure, particularly if the fixed exchange rate harms the economy or creates trade imbalances. Watching the countries' published levels of exchange reserves can give some early warning signs of how difficult it is to maintain the current peg.
FX traders should never underestimate the volatility and risk associated with a de-peg. Just such a scenario caused a 20% surge in the value of the Swiss Franc in 2015 when Switzerland unexpectedly announced it would no longer maintain its peg against the Euro at 1.20. With some traders exposed to highly leveraged positions that couldn't be exited in time, they lost their account balances, and some were open to further claims and legal action.