Introduction:

Pegging is controlling a country's currency rate by tying it to another country's currency. A country's central bank, at times, will engage in open market operations to stabilize its currency by pegging, or fixing, it to another country's presumably more stable currency. Pegging can also refer to the practice of manipulating the price of an underlying asset, such as a commodity, prior to option expiry.

Currency Pegging:

A country's central bank will go into the open market to buy and sell its currency in order to maintain the pegged ratio that has been deemed to provide optimal stability. If a country’s currency value experiences large fluctuations, foreign companies have a more difficult time operating and generating a profit. If a U.S. company operates in Brazil, for example, the firm has to convert U.S. dollars into Brazilian reals to fund the business. If the value of Brazil’s currency changes dramatically compared to the dollar, the U.S. company may incur a loss when it converts back into U.S. dollars. This form of currency risk makes it difficult for a company to manage its finances. To minimize currency risk, many countries peg an exchange rate to that of the United States, which has a large and stable economy.

Advantages:

Pegged currencies can expand trade and boost real incomes, particularly when currency fluctuations are relatively low and show no long-term changes. Without exchange rate risk and tariffs, individuals, businesses, and nations are free to benefit fully from specialization and exchange. According to the theory of comparative advantage, everyone will be able to spend more time doing what they do best. With pegged exchange rates, farmers will be able to simply produce food as best they can, rather than spending time and money hedging foreign exchange risk with derivatives. Similarly, technology firms will be able to focus on building better computers. Perhaps most importantly, retailers in both countries will be able to source from the most efficient producers. Pegged exchange rates make more long-term investments possible in the other country. With a currency peg, fluctuating exchange rates are not constantly disrupting supply chains and changing the value of investments.

Disadvantages:

The central bank of a country with a currency peg must monitor supply and demand and manage cash flow to avoid spikes in demand or supply. These spikes can cause a currency to stray from its pegged price. That means the central bank will need to hold large foreign exchange reserves to counter excessive buying or selling of its currency. Currency pegs affect forex trading by artificially stemming volatility.

Countries will experience a particular set of problems when a currency is pegged at an overly low exchange rate. On the one hand, domestic consumers will be deprived of the purchasing power to buy foreign goods. Suppose that the Chinese yuan is pegged too low against the U.S. dollar. Chinese consumers will have to pay more for imported food and oil, lowering their consumption and standard of living. On the other hand, the U.S. farmers and Middle East oil producers who would have sold them more goods lose business. This situation naturally creates trade tensions between the country with an undervalued currency and the rest of the world.