The Dollar Peg: How It Works and Why It's Done

Why Countries Peg Their Currencies to the Dollar

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A dollar peg is when a country maintains its currency's value at a fixed exchange rate to the U.S. dollar. The country's central bank controls the value of its currency so that it rises and falls along with the dollar. The dollar's value fluctuates because it’s on a floating exchange rate. 

At least 66 countries either peg their currencies to the dollar or use the dollar as their legal tender. The dollar is so popular because it's the world's reserve currency. World leaders gave it that status at the 1944 Bretton Woods Agreement.

The runner-up is the euro. Twenty-five countries peg their currencies to it. The 19 eurozone members use it as their currency.

Key Takeaways

  • The dollar peg is used to stabilize exchange rates between trading partners.
  • A country that pegs its currency to the U.S. dollar seeks to keep its currency’s value low. A lower value currency vis-à-vis the dollar allows the country’s exports to be very competitively priced.
  • Compared to the floating exchange rate, dollar-pegging promotes anti-competitiveness in trade with the United States.
  • The yuan’s peg to the dollar allows the United States to buy cheap imports from China. But the price of such an advantage is the loss of U.S. manufacturing jobs.

How It Works

A dollar peg uses a fixed exchange rate. A country's central bank promises to give you a fixed amount of its currency in return for a U.S. dollar. The country must have lots of dollars on hand to maintain this peg. As a result, most of the countries that use a U.S. dollar peg have significant exports to the United States. Their companies receive lots of dollar payments. They exchange the dollars for local currency to pay their workers and domestic suppliers.

Central banks use the dollars to purchase U.S. Treasurys. They do this to receive interest on their dollar holdings. If they need to raise cash to pay their companies, they may sell Treasurys on the secondary market.

A country's central bank will monitor its currency exchange rate relative to the dollar's value. If the currency falls below the peg, it needs to raise its value and lower the dollar's value. It does this by selling Treasurys on the secondary market. That gives the bank cash to purchase local currency. By adding to the supply of Treasurys for sale in the market, their value drops, along with the value of the dollar. This adjustment reduces the supply of local currency, raising its value, and the peg is restored.  

Keeping the currencies equal is difficult since the dollar's value changes constantly. That's why some countries peg their currencies' value to a dollar range instead of an exact number.

Example of a Fixed Exchange Rate

China switched from a fixed exchange rate in July 2005. It is now more flexible but still managed with a close eye. It prefers to keep its currency low to make its exports more competitive.

China's currency power comes from its exports to America. The exports are mostly consumer electronics, clothing, and machinery. In addition, many U.S.-based companies send raw materials to Chinese factories for cheap assembly. The finished goods become imports when they are shipped back to the United States.

Chinese companies receive American dollars as payment for their exports, which they deposit into their banks in exchange for yuan to pay their workers. Local Chinese banks transfer dollars to China's central bank, which stockpiles them in its foreign currency reserves. The Chinese Central Bank holdings reduce the supply of dollars available for trade. That puts upward pressure on the dollar.

China's central bank also uses the dollars to purchase U.S. Treasurys. It needs to invest its dollar stockpile into something safe that also gives a return, and there's nothing safer than Treasurys. China knows this will further strengthen the dollar and lower the yuan's value.

Why Countries Peg Their Currencies to the Dollar

The U.S. dollar's status as the world's reserve currency makes many countries want to peg. One reason is that most financial transactions and international trade are made in U.S. dollars. Countries that are heavily reliant on their financial sector peg their currencies to the dollar. Examples of these trade-reliant countries are Hong Kong, Malaysia, and Singapore.

Other countries that export a lot to the United States peg their currencies to the dollar to maintain competitive pricing. They try to keep the value of their currencies lower than the dollar. The lower currency value gives them a comparative advantage by making their exports to America cheaper. 

Japan doesn't exactly peg the yen to the dollar. Its approach is similar to China. It tries to keep the yen low compared to the dollar because it exports so much to the United States. Like China, it receives a lot of dollars in return. As a result, the Bank of Japan is the largest purchaser of U.S. Treasurys.

Other countries—like the oil-exporting nations in the Gulf Cooperation Council—must peg their currencies to the dollar because oil is sold in dollars. As a result, they have large amounts of dollars in their sovereign wealth funds. These petrodollars are often invested in U.S. businesses to earn a greater return. For example, Abu Dhabi invested petrodollars in Citigroup to prevent its bankruptcy in 2008.

Countries that do a lot of trading with China will also peg their currencies to the dollar. They want their exports to be competitive with the Chinese market. They want their export prices always to be aligned with the Chinese yuan. Pegging their currencies to the dollar accomplishes that.

Frequently Asked Questions (FAQs)

What happens if a currency peg breaks?

When a country abandons its currency peg, the effects can be significant, but they ultimately depend on a variety of other economic factors within the country. One study that examined 21 different instances where a country broke its currency peg showed that most countries showed some degree of economic disruption, including a slowdown in production, sudden drops in currency value, inflationary pressures, and rising unemployment. These disruptions eventually stabilize, but it can take quite some time, depending on the other factors involved.

What are the risks of pegging one currency to another?

Creating a fixed exchange rate can have some benefits, but it also brings risk to the country that's pegging its currency to another's. Overall, it can be difficult to maintain the foreign exchange reserves necessary to keep the peg in place. It can also make the country's currency vulnerable to speculation. If the currency is pegged too high or too low, there also can be adverse effects in trade and inflationary pressures.

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