Pegging a nation’s currency to that of a trading partner has some advantages. It allows businesses to plan; exporters and importers can agree on prices without worrying about sudden foreign-exchange fluctuations. Until the early 1970s, most global currencies were pegged to the dollar under the Bretton Woods system. Since then, pegs have been adopted for three main reasons by varying groups of countries.
The first group, of which China is an example, dislikes the fluctuations of the free market. These countries prefer to manage their currencies, along with maintaining the capital controls that a peg implies. A second group sees currency pegs as a way to gain economic credibility: Argentina’s currency board in the 1990s was designed to help end the hyperinflation of the 1970s and 1980s. In effect, America’s Federal Reserve, not the Argentine central bank, set monetary policy. The third group is the euro-zone countries, which saw currency links through the Exchange Rate Mechanism (ERM) as a way to boost economic integration, a process that ended with the creation of the euro in 1999.
Yet pegs have problems. Economic policy must be subordinated to the exchange-rate target. If monetary policy in the target country is tightened, then the pegger must tighten too. If the two economies are not closely linked, such a policy shift may be completely inappropriate. And markets can sense weakness. Traders may try to break the peg, as happened when Britain was forced out of the ERM in 1992. The central bank may run out of reserves in an attempt to hold the peg, and the policy will have to be abandoned.