A currency peg is a fixed exchange rate system where a country's central bank maintains its currency at a constant rate against another currency or currency basket—typically the U.S. dollar or euro.
How Currency Pegs Work
The central bank actively buys or sells its own currency to keep the exchange rate at the target level. If the currency strengthens beyond the peg, the bank sells it and buys foreign reserves to weaken it back. The rate stays constant or within a narrow band set by authorities.
Why Countries Use Currency Pegs
- Creates predictable pricing for international trade
- Builds confidence in the domestic currency
- Helps smaller or emerging economies reduce exchange-rate volatility
Key Risks and Challenges
- Limited monetary policy independence: Interest rates and money supply must support the peg, restricting the central bank's response options during economic crises.
- Speculative attacks: If traders believe the peg cannot hold, they may attack the currency, forcing the central bank to deplete reserves rapidly.
- Poor shock absorption: Pegged currencies cannot depreciate to ease economic adjustment, making recessions harder to manage.
- Sudden breaks: When speculators overwhelm the central bank, the peg can break abruptly, causing sharp currency shifts.
Trading Implication
Pegged currencies appear stable, but that stability depends on the central bank's resources. If the peg breaks, the exchange rate can shift sharply, creating sudden losses or gains for traders holding the currency.
