Ever heard of currency pegging? You might have come across the term while researching trading. Well, this article is going to break currency pegging down to the basics—what it means, how it works, and why it’s a method used by governments and central banks around the world.  

What’s a currency peg?   

Let's start with the basics—a currency's exchange rate is its value in relation to another currency. And a currency peg is a strategy wherein a government or central bank stabilizes the value of its currency by fixing its exchange rate with another currency or a basket of currencies.   

Some currencies are free-floating, with rates that move with supply and demand in the market, while others are fixed and tied to one another. So, in general, currency pegging allows for long-term predictability of currency rates, which is useful for maintaining economic stability and a range of other reasons that we'll uncover below. 

How it works 

Primarily, a currency peg is used to lower the cost of international commerce by mitigating currency fluctuations. That, in turn, can help promote trade between countries.  It is common practice for nations to "peg" their currency to that of a more economically healthy or industrialized nation, allowing their domestic businesses easier access to foreign markets. 

If a country's central bank wanted to peg its currency, it could fix it at a predetermined rate of exchange relative to another currency. The government might also peg its currency to a basket of currencies rather than a single one, or it could set a range within which the currency may trade.  

The policy of a fixed exchange rate would then be communicated to the general public by the country's monetary authority. After that, it will use open currency market activities to protect the targeted fixed rate or range of rates. Currency controls and banning currency transactions at any rate other than the fixed rate have helped various countries keep their exchange rates stable. 

This restrictive currency policy can be difficult to implement and can potentially lead to the creation of a black market, but countries with strict government oversight of currency exchanges have found success with this strategy—for example, China. 

Pros 

1. Pegging makes long-term investments in foreign countries a lot more palatable to investors by protecting them from how changes in currency affect the supply chains and a currency's value. 

2. A currency peg could help businesses with lower margins that can't afford foreign currency hedges and can't afford to lose money if the exchange rate changes unexpectedly. Also, a stable currency and a mutually beneficial economic climate could be advantageous to many sectors because they wouldn't have to worry about how changes in exchange rates affect their profitability. 

3. Pegged currencies could increase trade and earnings as long as currency fluctuations are modest, and no big shifts are expected in the long term. If exchange rate risks and tariffs didn't matter, it's possible that people, businesses, and governments could all stand to gain more from specialization and exchange. 

Cons 

1. Pegging a currency to an unrealistically low exchange rate runs the risk that domestic customers won't be able to afford foreign items. Imported goods like food and oil would cost more for the country's consumers, which could lead to less overall consumption and a lower standard of living. What's more, the sudden drop in demand could cause trade tensions between the two countries to skyrocket. 

2. A country's central bank has to be really careful about controlling its cash flow so that supply and demand don't make the value of its currency fluctuate sharply. Because of these changes, the central bank of a country might need to keep a lot of foreign exchange reserves on hand. 

3. A very high peg rate could make it impossible for a government to control its currency in the long run. People in the country might be tempted to buy a huge amount of imported goods, boosting demand. If this were to happen, the government would likely have to use foreign exchange reserves in order to maintain the peg because the local currency would be under constant pressure from trade deficits. And if the government's reserves run dry, the peg would collapse. 

Currency pegging and stablecoins 

Due to their many benefits, currency pegs are slowly making their way into the cryptocurrency industry. A stablecoin is the latest form of pegging in the world of cryptocurrencies—it's essentially a cryptocurrency whose value is tied to a stable asset, like fiat money.  

Stablecoins are very important in a market like crypto, where prices go up and down a lot. For one thing, they make it easy to change digital currency into a stable fiat currency right away. In that way, we can think of them as an attempt to combine the benefits of cryptocurrencies with the security and dependability of traditional fiat currency.  

In the future, stablecoins could very well help solve the liquidity problems of many cryptocurrency exchanges, and the technology behind them could make it possible to add more financial services like loans and insurance to the cryptocurrency market. 

Final thoughts 

A currency peg is a policy in which the exchange rate of one country's currency is set based on that of another. Most countries choose to peg their currencies in order to encourage trade and international investment, reduce the risks of entering new markets, and keep their economies stable. It has its pros and cons, but it has worked well for different countries with rigid regulations, and it's even starting to be seen in the cryptocurrency market through stablecoins.