What are currency pegs?

A currency peg (also called a fixed exchange rate) is a policy regime in which a country fixes its currency's value relative to another currency, typically the US dollar, and commits to maintaining that rate through central bank intervention. The Hong Kong dollar has been pegged to the US dollar at a rate of roughly 7.75-7.85 since 1983. Saudi Arabia pegs the riyal at 3.75 per dollar. China maintained a strict dollar peg until 2005 and now operates a managed float.

To maintain a peg, the central bank must be willing to buy or sell unlimited quantities of its own currency at the fixed rate. If the market wants to sell the domestic currency (pressure to depreciate), the central bank must buy it using foreign exchange reserves. If the market wants to buy the domestic currency (pressure to appreciate), the central bank must sell it and accumulate reserves. This intervention requires large foreign reserve holdings and imposes a constraint: the central bank cannot set domestic interest rates independently because capital would flow toward the higher-yielding currency, creating unsustainable intervention pressure.

Currency pegs offer benefits including exchange rate predictability for trade and investment, an inflation anchor (importing the anchor currency's monetary policy credibility), and reduced transaction costs for international business. These benefits explain why many commodity-exporting economies (Gulf states) and trade-dependent economies (Hong Kong, Denmark) maintain pegs.

The risks of pegging are demonstrated by dramatic failures. The UK's exit from the European Exchange Rate Mechanism in 1992 (when George Soros "broke the Bank of England"), the Asian currency crises of 1997 (Thailand, Indonesia, South Korea), and Argentina's abandonment of its dollar peg in 2001 all resulted in devastating economic consequences when market forces overwhelmed central bank reserves. The key vulnerability is that maintaining a peg during periods of divergent economic conditions between the pegging country and the anchor country creates pressure that builds until reserves are exhausted or the peg is abandoned.