The Pros and Cons of a Currency Peg
Nigeria, the home of Africa’s largest economy, recently unpegged its currency the naira, from the US dollar. This was a result of many businesses and economists blaming the currency peg for the country’s slide towards a recession. The naira is now trading at a market-determined rate rather than sticking with the US dollar.
There are many pros and cons that a currency peg provides, both for a country’s economy and forex traders. Whether you’re simply interested in finances or are a trader yourself, here are the advantages and disadvantages of a currency peg.
What is a Currency Peg?
A currency peg is essentially when one currency’s value is fixed to another’s. For example, with the Nigerian naira it was pegged to the US dollar, so that whenever the dollar rose in value, so would the naira. This makes up part of a country’s exchange-rate policy, helping to stabilise the exchange rate between countries.
With a currency peg, it means that everything is incredibly predictable and that things will cost the same between the two currencies no matter what else is going on in the world’s economy. For some countries it has proven highly successful, with the Hong Kong dollar pegged to the US dollar since 1983 and the Danish kroner to the euro from 1982 for example.
Pros of Pegging Currency
Pegging has been a popular practice now for some time now and it can be advantageous for several reasons.
For a Country
Pegging currency helps make trading a lot more predictable, which is incredibly useful for countries that rely a lot on exports for their GDP. The country, exporters and importers do not have to worry about changing exchange rates and their impact upon trade. It also helps countries with low production costs to keep exports cheap, as when times are good the peg keeps the currency artificially cheap. Fixing to a stable currency also prevents against hyperinflation.
When a currency is pegged it makes its movements a lot more predictable, which can be useful for traders using online platforms. When such a large currency, such as the US dollar is predicted to increase in value, savvy traders can invest in one of its pegged currencies which will inevitably follow suit.
Cons of Pegging Currency
As the Nigerian naira has shown though, pegging a currency doesn’t always lead to success. There are a few risks involved for the government and traders.
For a Country
The central bank loses some control over its basic policy making when pegging to another currency. For example, it will have less control over interest rates if it needs to try and tackle inflation and the pegged currency is doing well. When pegs are broken it can also be highly problematic and lead to large fluctuations, impacting upon trade and exchange rates.
Pegs minimise currency fluctuation, resulting in fewer opportunities for traders to make a profit on the forex market. While there is also a lot of predictability, when a currency peg does break there can be large fluctuations that catch out traders, had they not prepared for them.
Currency pegs have various pros and cons therefore, which you should be aware of when trading forex.