A currency peg is a system where a country’s government or central bank fixes its currency’s value to another currency, a basket of currencies, or a commodity like gold.
This means that instead of allowing its currency to fluctuate freely based on supply and demand, the country keeps its exchange rate stable at a set level. Pegged currencies are often linked to major global currencies like the US dollar or the euro to provide economic stability and predictability in international trade.
Countries use currency pegs to reduce exchange rate volatility, which can help businesses and investors plan ahead with more confidence. By maintaining a fixed exchange rate, governments can promote trade and investment by making it easier for businesses to conduct international transactions without worrying about currency fluctuations.
Pegged currencies are especially common in economies that rely heavily on exports, tourism, or foreign investment.
To maintain the peg, a central bank must actively manage its currency’s value. This is done by buying or selling foreign reserves to keep the exchange rate stable.
If the local currency weakens, the central bank may use its foreign reserves to buy back its own currency, increasing demand and strengthening its value.
If the currency becomes too strong, the central bank may print more money or buy foreign currencies to bring its value back down.
There are different types of currency pegs.
A hard peg means the exchange rate is completely fixed with no fluctuations, while a soft peg allows for some controlled movement within a specific range. Some countries operate under a crawling peg, where the fixed rate is adjusted periodically to reflect economic conditions.
While currency pegs can provide economic stability, they also come with risks. If a country’s economy faces financial pressure, defending a peg can become expensive and unsustainable. A central bank may run out of foreign reserves trying to maintain the exchange rate, forcing it to abandon the peg. History has seen several major currency crises where pegs collapsed, leading to sharp devaluations and financial turmoil.
Currency pegs directly impact international trade, investment strategies, and financial risk management which make them an important factor about which to be aware when dealing with currencies outside of your base currency.