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What is Currency Pegging and Is It Healthy for the Economy?

Various countries and governments around the world have been seeking to stabilize their countries’ economies by pegging their domestic currency to a major strong currency – mostly the USD and the Euro.

Countries like Egypt, Morocco, Bahrein, Ivory Coast, Venezuela and even China have been pegging to various degrees in order to protect their economies. While some would encourage such practice claiming that it provides stability and visibility, others heavily criticize it by emphasizing on its inefficient and anti-liberal nature. We will inspect all aspects of currency pegging and come up with a concrete answer on the topic.

elephant walk on dollar carpet

So let’s first understand how the practice of pegging works and assess whether countries do benefit from it.

How Does Currency Pegging Work?

We all know that prices are always defined by supply and demand. The higher the demand for a product, the higher its price. Similarly, the higher the demand for a currency, the higher its value relative to other currencies.

In other words, whenever we buy a foreign currency, we do sell the domestic currency. In this process we increase demand for the foreign currency and increase supply for the domestic currency. As a logical result, we contribute towards the appreciation of the foreign currency against the domestic one.

To illustrate, let’s say that we are based in the US and we buy packaged medicaments from Israel. In order to do so, we need to exchange our Us Dollars into Israeli Shekels and use the shekels to pay abroad to buy the medicaments. In this process we supply US Dollars while increasing demand for Israeli Shekels – as a result we contribute to appreciate the Shekel.

Related: How economy impacts currencies

Now some countries would not want their currency to fluctuate and would seek to fix their exchange rate by intervening in the markets. Whenever demand would increase for their currency, they would supply it and buy foreign reserves. Oppositely, whenever demand for their currency would decrease, they would use foreign reserves in order to buy their own currency and therefore keep its value stable.

Other mechanisms could also be used to manipulate a country’s currency. For instance, some central banks would decide to reduce interest rates in order to appreciate their currencies and vice-versa. Obviously the mandate of central banks is not really related to currency control and an interest rates change usually targets inflation and unemployment – yet it would at the same time impact the currency.

To explain the mechanism behind it, imagine that the FED increases interest rates in the US. Higher interest rates mean that it becomes more expensive to borrow money and people get incentivised to rather save than borrow. As people get to borrow less, the money supply decreases therefore making the US Dollar more scarce. Logically, the US Dollar consequently appreciates.

Obviously low interest rates policies usually yield the opposite impact and lead to a depreciation of the currency.

 

Advantages of Pegging

Usually merchants, traders and entrepreneurs want to be able to plan and have visibility over the long term. While some would favour gambling on exchange rates changes, most would favour a stable currency.

While a floating currency enables efficiency, it adds a layer of risk to businesses – especially those dealing with foreign countries (corporate FX). A company might be really skilled at producing or selling, yet it might incur massive losses because of exchange rate changes. Similarly, a foreign entrepreneur might be highly interested in our country’s economic potential, yet an unstable currency might deter him from investing.  

Therefore pegging our domestic currency to our main trading partner provides guarantees to business, investors and merchants. It enables them to grow safely while focusing on their core competencies. This stability encourages further business and trade, it increases exchanges and boosts the economy.

 

Disadvantages of Pegging

As we all know, every good thing has a cost. While it is true that pegging has many advantages, it does have costs. Basically, when a currency is under pressure and as the central bank seeks to stabilize the exchange rate, it sells foreign currency. Yet, foreign currency reserves are limited there comes a point where the central bank can not act anymore – which takes down the whole castle. This situation recently happened in Egypt. As capital flew out from the country and as the central had no more reserves, it had no more choice and needed to let the Egyptian Pound freely float. Overnight, the Pound massively depreciated and a crazy inflation hit the country.

Besides, pegged currencies are not able to benefit from the positive effect of a natural depreciation. Indeed, depreciation enables a country’ products to gain competitiveness, it enables to increase tourism and to attract more foreign investors. Therefore, a country with a free floating regime will see its currency adapt to the natural state of its economy. During downturns, its currency will depreciate – which in itself will contribute to support the economy’s recovery.

Simply said, a free floating currency is a self-regulating mechanism that enables an economy to naturally grow and react to major global trends.

The Debt Barrier

One of the most important issues preventing pegged currency regimes to float their currency is debt. For many of these countries, debt has been incurred in whether Dollar or Euro. So those countries would borrow money while having some benchmarks in mind. Based on the country’s situation, they would target a particular ratio of Debt to GDP and seek to stabilize their debt around it.

The issue that happens is that the day they go floating, their currency depreciates – meaning their debt increases and they can no longer respect the target ratio. As a consequence, financing costs sky rocket and things turn sour.

Usually they can overturn the situation but only in the middle term once their economy has adjusted. However most politicians do not want to be in the “eye of the cyclone” and would avoid the risk around free floating. Even if necessary, they would kind of procrastinate on it and let the next guy in charge handle the hot potato.

 

Special Case: the Eurozone

While we will look into this topic in more details in future dedicated articles, it is worth noting that Eurozone countries do not benefit in the same way from the Euro. When countries like Spain, Greece and Portugal need a weaker Euro in order to boost their competitiveness, others such as Germany are very happy with a strong Euro.

Should there have been local currencies for each country, the currencies would have adapted to each country’s situation – therefore helping the country’s economy and enabling higher GDP growth for the countries that are in the most precarious situation.

The single currency (which we could somewhat relate to a peg of all currencies at the same time) does encourage more trade between Union member, yet it favours the strongest economies.

 

Final Words on Currency Pegging: Necessary Evil?

Well, truth to be told, free floating is definitely more natural and efficient than pegging currencies. On the short term, pegging could sound like a good shortcut, yet getting out of it can be extremely difficult to handle. It is no surprise that most developed countries have free floating currencies, while at the same time it is a needed measure at times of disarray. Developing a liquid forward market enables to provide stability and enable risk mitigation, but it’s not always feasible and thus currency pegging is somewhat of a necessary evil.

 

Foreign Currency is Our Expertise.

If you want to know even more international money transfers then you should know our expert staff has written more than 20 articles on the subject, readily available for your pleasure.

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