A dollar peg is when a nation keeps its currency’s value at a fixed currency exchange rate to the U.S. dollar. The country’s reserve bank manages the value of its currency so that it fluctuates in addition to the dollar. The dollar’s worth varies since it’s on a drifting currency exchange rate.
At least 66 countries either peg their currencies to the dollar or utilize the dollar as their legal tender.1 The dollar is so popular due to the fact that it’s the world’s reserve currency. World leaders offered it that status at the 1944 Bretton Woods Agreement.2.
The runner-up is the euro. Twenty-five nations peg their currencies to it. The 19 eurozone members utilize it as their currency.3.
Key Takeaways.
The dollar peg is utilized to stabilize currency exchange rate between trading partners.
A nation that pegs its currency to the U.S. dollar looks for to keep its currency’s value low. A lower value currency vis-à-vis the dollar allows the country’s exports to be extremely competitively priced.
Compared to the drifting exchange rate, dollar-pegging promotes anti-competitiveness in trade with the United States.
The yuan’s peg to the dollar enables the United States to purchase cheap imports from China. The cost of such a benefit is the loss of U.S. production tasks.
How It Works.
A dollar peg uses a set currency exchange rate. A nation’s central bank promises to give you a repaired quantity of its currency in return for a U.S. dollar. The country must have lots of dollars on hand to preserve this peg. As an outcome, most of the countries that utilize a U.S. dollar peg have significant exports to the United States. Their business get lots of dollar payments. They exchange the dollars for local currency to pay their employees and domestic providers.
Central banks use the dollars to buy U.S. Treasurys. They do this to receive interest on their dollar holdings. If they need to raise cash to pay their business, they may offer Treasurys on the secondary market.
A country’s main bank will monitor its currency exchange rate relative to the dollar’s worth. If the currency falls below the peg, it requires to raise its value and lower the dollar’s value. By including to the supply of Treasurys for sale in the market, their worth drops, along with the worth of the dollar.
Keeping the currencies equal is hard because the dollar’s value modifications constantly. That’s why some countries peg their currencies’ value to a dollar range rather of a precise number.
Example of a Fixed Exchange Rate.
China changed from a fixed currency exchange rate in July 2005. It is now more versatile however still handled with a close eye.4 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 primarily consumer electronic devices, clothing, and machinery. In addition, numerous U.S.-based business send basic materials to Chinese factories for inexpensive assembly. The ended up items end up being imports when they are shipped back to the United States.
Chinese companies get American dollars as payment for their exports, which they transfer into their banks in exchange for yuan to pay their workers. Regional Chinese banks move dollars to China’s central bank, which stockpiles them in its foreign currency reserves. The Chinese Central Bank holdings lower the supply of dollars offered for trade. That puts upward pressure on the dollar.
China’s central bank also utilizes the dollars to buy U.S. Treasurys. It needs to invest its dollar stock into something safe that also provides a return, and there’s absolutely nothing more secure than Treasurys. China knows this will even more reinforce the dollar and lower the yuan’s worth.
Why Countries Peg Their Currencies to the Dollar.
The U.S. dollar’s status as the world’s reserve currency makes lots of nations wish to peg. One factor is that many financial transactions and international trade are made in U.S. dollars. Nations that are heavily reliant on their monetary 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 keep competitive rates. They try to keep the value of their currencies lower than the dollar. The lower currency value provides a comparative benefit by making their exports to America less expensive.
Japan doesn’t precisely peg the yen to the dollar. It tries to keep the yen low compared to the dollar since it exports so much to the United States.
Other countries– like the oil-exporting countries in the Gulf Cooperation Council– must peg their currencies to the dollar since oil is offered in dollars.6 As a result, they have large amounts of dollars in their sovereign wealth funds. These petrodollars are typically invested in U.S. businesses to make a greater return. Abu Dhabi invested petrodollars in Citigroup to prevent its insolvency in 2008.78.
Nations that do a great deal of trading with China will likewise peg their currencies to the dollar. They desire 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.
