Advantages and Disadvantages of Currency Pegs

Advantages of Currency Pegs

Currency pegs have become extremely popular in the post Bretton Woods monetary world. About one fourth of all countries in the world today have pegged their currencies to some other major currency like the dollar or the euro.

This strategy has bankrupted certain nations like Argentina whereas it has caused other nations like China to reach economic success. Therefore, this strategy has certain advantages as well as certain disadvantages. In this article, we will list down both the advantages as well as disadvantages.

1. Stable Basis for Planning: Currency pegs provide an extremely stable basis for financial planning to the governments. Governments have to buy essential commodities such as oil and food grains from the international market. Here, the government has to pay its expenses in a foreign currency. Usually this foreign currency is the United States dollar since it is the reserve currency of the world. However, other currencies like the Euro are also accepted in the international market nowadays.

   However, the issue remains the same regardless of whether the Dollar is used or the Euro. The government has to convert its own currency to another one at the Forex market. If the rates are constantly fluctuating, the government cannot anticipate how much of its own currency will it require so that it can convert it to foreign currency and meet the demand. On the other hand, currency pegs fix the rate and provide a stable basis for governments to plan their revenues and expenditures in local currencies without any concerns about the volatile rates.

2. Credible And Disciplined Monetary Policy: Currency pegs are often popular in third world countries. Impoverished countries from South America, Asia and Africa have used currency pegs in the past. This is because these impoverished countries are also breeding grounds for corruption. Hence, these countries do not trust their local leaders with their monetary policy. There is a big chance that the people that come to power may end up causing hyperinflation. A case in point would be President Robert Mungabe from Zimbabwe who basically destroyed the Zimbabwean currency for personal gain.

   Hence, such countries want to outsource their monetary policy to a more developed nation where the policymakers would take more responsible decisions. This only partially offsets the threat of sabotage from local politicians. This is because politicians can still order printing of money and cause inflation. However, they cannot reduce interest rates and cause a bubble in the economy in general when a currency peg is being followed.

3. Reduced Volatility: Apart from the governments, the local businesses also face advantages as a result of currency pegs. The local businesses can predict how their goods will be priced in the international market. Once they are aware of the exact pricing, they can also predict the quantities that will be demanded at that price. As such, they do not face any volatility and can insulate themselves from foreign exchange losses. This puts them at a major advantage as compared to other competitors who have to face such risks and as such have to include a risk premium for the same in their prices.

Disadvantages of Currency Pegs

1. Increased Foreign Influence: On the flipside, countries which adopt a currency peg face increased foreign influence in their domestic affairs. This is because their monetary policy is determined by another nation. A lot of times, this leads to a conflict situation.

   Consider the case of the attack on the Pound Sterling. During that time the British government had pegged its currency to the German Deutschemark. German Bundesbank increased the interest rates because of domestic concerns on inflation.

   The British wanted the interest rates to fall. However, there was no drop in the rates. As such, the British pound took a severe beating because the Bank of England was no longer in control of its affairs and the Bundesbank had an increased influence in Britain’s domestic affairs.

2. Difficulty in Automatic Adjustment: A floating currency system leads to automatic adjustment of deficits. For instance, if one country imports too much, they will have to pay out a lot. This will lead to a decrease in the currency supply in their economy causing deflation. Deflation means low prices and low prices make their exports competitive.

   Hence, increasing imports automatically lead to a situation of increasing exports! The freely floating system tends towards equilibrium. However, currency pegs tend to exaggerate disequilibrium.

   Consider the case of the massive trade and current account deficits between United States and China and the fact that at the root cause, they have been caused by a peg between the dollar and the Yuan. Therefore, currencies that have pegs with other currencies are prone to disequilibrium. This has happened several times in the short economic history of freely floating currencies and is expected to happen several more times in the future.

3. Speculative Attacks: Speculative attacks on a currency can only happen if it deviates too much from its value. Freely floating currencies do not deviate too much from their value. As soon as there is a deviation, the market mechanism sets in and correction happens instantaneously. However, on the other hand, currency pegs can allow a huge difference in the fundamental value of a currency and its market value. This is because the Central Bank tries to artificially manipulate the value.

   There are some financial funds with deep pockets that can even take on Central Banks and such cases have happened several times. When currencies have ventured too far from their fundamental value, speculators have been able to force devaluations on such currencies.

   Also, sometimes the speculative attacks are so severe that countries have to abandon the pegs and allow their currencies to freely float within a couple of days. Whenever such an attack occurs, the common man of the country suffers increased losses since foreign trade as well as foreign investments face a massive impact.

   A currency which is already freely floating is at a much lower risk of such an attack. Hence, this can be considered to be a major disadvantage of currency pegs.