What is a currency peg?

What is a currency peg?

The currency pairs you are most familiar with, such as EUR/USD or USD/JPY, are floating currencies, meaning that their value changes freely with market forces.

Some countries have chosen to peg their currency to another currency, most commonly the USD. The exchange rate between their currency and the peg currency never changes, unless policy makers tweak things slightly.

Currencies can also be pegged to commodities or baskets of other currencies. Pegged currencies are not discussed often in the Forex market because their value is tied directly to the value of another, more liquid floating currency, or to a basket of currencies, or to a commodity.

The exchange rate between a pegged currency and the base currency does not change, but the value of the base currency (or basket, or commodity) will fluctuate with market conditions. Approximately 65 countries either peg their currencies to the US Dollar or use the dollar as their domestic currency.

The dollar is the primary reserve currency of the world, with some estimating that there are more US dollars held abroad than within the border of the US, and pegging to this currency can offer a lot of stability. Some countries, such as Saudi Arabia, peg their currency to the US dollar simply because oil is such a large part of their economy and the USD is the primary currency of the oil trade.

A basket of currencies, which is sometimes used as a peg, is a weighted mix of certain currencies that functions like an index. Sometimes countries cannot sustain their peg to the USD or another benchmark, as happened with Thailand in the 1990s when their central bank ran out of USD reserves.

Sometimes countries will voluntarily un-peg their currency, but this can throw their economy into a downward spiral as investors sell off that currency. There is also a crawling peg, in which the exchange rate to the pegged currency is range-bound but has some flexibility within the range.

Pegging is also referred to as “anchoring.”