What Causes a Currency Peg to Break?

Currency pegging is one technique that nations use to stabilize their economies by tying their currency’s value to that of a stronger, more stable currency, often the US dollar or euro.

However, these pegs are not invincible.

They can, and do, break under certain circumstances, especially when the exchange rate is out of whack relative to economic fundamentals.

Here we look into the primary reasons that cause a currency peg to break.

We’ll also look at the factors traders can look for in order to anticipate a currency peg breaking.

Key Takeaways – What Causes a Currency Peg to Break?

• Currency pegging is an economic policy used by countries to stabilize their economies by fixing their currency’s value to a stronger, more stable currency.
• It aims to reduce exchange rate volatility, control inflation, and foster economic growth.
• Currency pegs are not indestructible and can break under certain circumstances.
• Factors such as economic instability, market speculation, exhaustion of foreign exchange reserves, political instability, and high inflation can lead to the collapse of a currency peg.
• Maintaining a currency peg requires careful management of foreign exchange reserves, interest rates, and capital controls.
• Additionally, creating a stable political and economic environment is important for preventing the peg from breaking and to ensure investor confidence.
• As a trader, watch for depleting foreign reserves, high inflation, economic instability, interest rate changes, political risk, current account deficits, and capital controls to anticipate a currency peg breaking.

What is a Currency Peg?

Currency pegging is an economic policy adopted by countries wherein they fix the exchange rate of their currency to another country’s currency or to a basket of currencies.

It can either be a hard peg or a range.

Commonly, countries will peg their currency to that of the world’s top reserve currency or that of their top trade partner (sometimes this is both – e.g., Vietnam pegs its currency, the dong, to the USD, with the USD as the top reserve currency and the US its top trade partner).

Sometimes it’s done against a basket of currencies like the CFETS basket with the Chinese renminbi.

The CFETS basket initially included the USD, euro, Japanese yen, and 11 other currencies. In 2020, the PBOC announced that the CFETS basket would expand to 24 foreign currencies, but the weights of these currencies weren’t specified.

It’s a monetary arrangement that aims to stabilize the exchange rate, control inflation, and foster economic growth by reducing exchange rate volatility.

Why Do Countries Peg Their Currency?

Countries mainly peg their currencies to stabilize their economies.

Pegging reduces the risk of currency value fluctuation, fostering a more predictable trade and investment environment.

When foreigners invest in a country it’s different than investing domestically because in the case of the former, it’s the returns from the assets + the returns from the currency.

It can also help to combat inflation and encourage economic growth when it’s set appropriately.

Economic Instability

One of the primary reasons for a currency peg to break is economic instability within the pegging country.

In times of economic recession or crisis, the pegging country’s currency may become overvalued relative to the pegged currency.

This leads to a disparity in exchange rates and can cause the peg to break.

Market Speculation

Market speculation is another major factor that can lead to a breaking of the currency peg.

If traders anticipate that a pegging country is unable to maintain the peg, they may begin to speculate against the pegged currency.

This “speculative attack” can cause a rapid outflow of foreign exchange reserves to defend the currency, eventually leading to the peg’s collapse.

Exhaustion of Foreign Exchange Reserves

Maintaining a currency peg requires significant foreign exchange reserves.

Countries must have enough reserves to buy and sell their own currency to maintain the peg.

If a country exhausts its foreign exchange reserves, it will be unable to maintain the peg, leading to its failure.

No prudent policymaker wants to run out of such savings, so they’ll eventually let the currency go.

We describe the relationship between the spot and forward pricing of a currency in such circumstances in this article.

Political Instability

Political instability can also cause a currency peg to break.

Political upheaval or changes in government can lead to policy changes that affect the peg.

If policy choices or other aspects of the political situation aren’t as favorable, investors might move some/all of their assets (and potentially themselves) out of the country.

High Inflation

High inflation can also lead to the breakdown of a currency peg.

When the inflation rate in the pegging country is significantly higher than that of the country to which it’s pegged, the real value of the pegging country’s currency can decline.

In such cases, they may raise interest rates to keep a favorable real yield.

But if left unchecked, it can undermine the peg and cause it to break.

What to Look For as a Trader in Order to Anticipate a Currency Peg Breaking

As a trader, anticipating the break of a currency peg can be highly beneficial.

There are several key indicators to monitor:

1. Depleting Foreign Exchange Reserves: If a country’s foreign exchange reserves are rapidly declining, it may suggest the central bank is having difficulties maintaining the peg. These reserves are important for the central bank to intervene in the currency market and maintain the fixed exchange rate.
2. High Inflation Rates: High or rising inflation can put pressure on a currency peg, especially if inflation is significantly higher than the country to which the currency is pegged.
3. Economic Instability: If a country is experiencing economic hardship, such as a recession or high unemployment, it may put pressure on the central bank to adjust monetary policy, potentially leading to a break in the peg.
4. Interest Rate Changes: A country with a currency peg must generally follow the interest rate policy of the country to which it is pegged. Significant differences in interest rates can create economic imbalances and can pressure the peg.
5. Political Risk: Political instability or changes in government policy can affect investor confidence, potentially leading to capital flight and putting pressure on the peg.
6. Large Current Account Deficits: A large current account deficit means the country is spending more on foreign trade than it is earning, and borrowing from other countries to make up the difference. This can lead to a devaluation of the currency and put pressure on the peg.
7. Capital Controls: If a government imposes new or more stringent capital controls, it may be a sign that the peg is under pressure and the government is attempting to prevent capital flight.

Is the Gold Standard an Example of a Currency Peg?

Yes, the gold standard is an example of a currency peg.

Under a gold standard, a country’s currency is pegged to a specific quantity of gold.

The central bank guarantees to exchange its currency for that quantity of gold upon demand.

This links the value of the currency directly to the value of gold, creating a fixed exchange rate between the currency and gold.

What Causes a Gold Standard to Fail?

A gold standard can fail due to several reasons:

1. Spending Too Much Relative to Income: A gold standard can fail if a country spends too much relative to its income, leading to large deficits and high debts, it can deplete its gold reserves and undermines the currency’s value, leading to a potential abandonment of the standard. This happened in the US in 1933 and 1971.
2. Limited Flexibility: A gold standard restricts the central bank’s ability to adjust monetary policy according to economic conditions. It can’t increase the money supply during a recession or decrease it during inflation without changing the gold reserves.
3. Economic Disparities: Countries with more gold reserves can maintain a more stable economy than those with fewer reserves, leading to economic disparities.
4. Deflation and Inflation: Changes in the global supply and demand for gold can lead to deflation (if gold becomes more scarce) or inflation (if gold becomes more plentiful), affecting economies tied to the gold standard.
5. Lack of Trust: A gold standard depends on the confidence that the government can, and will, exchange its currency for gold. If this trust is compromised, perhaps due to economic or political instability, it can lead to the failure of the gold standard.
6. Gold Supply Constraints: If a country’s economy grows faster than its gold reserves, it could lead to money supply issues, as there wouldn’t be enough new currency to support economic activities. This could also cause the gold standard to fail.

The HKD/USD Currency Peg

The Hong Kong Dollar (HKD) has been pegged to the US Dollar (USD) since 1983.

The peg was established to bring stability during a period of market volatility.

The exchange rate has been allowed to move within a narrow band of HKD 7.75 to 7.85 per USD.

The Hong Kong Monetary Authority (HKMA) maintains this peg through buying and selling USD as needed, adjusting the supply of HKD to keep the exchange rate within the desired band.

Why Do Many Expect the HKD/USD Peg to Fail?

There have been increasing speculations about the potential failure of the HKD/USD peg due to a combination of factors:

1. Political Unknowns: The ongoing political tension between Hong Kong and mainland China, which intensified after the national security law implemented by Beijing in 2020, has caused worries about the city’s future as a global financial hub. This political uncertainty has prompted concerns over the stability of the currency peg.
2. Economic Factors: The relative strength of the US dollar, the state of Hong Kong’s economy, and the policies of the Federal Reserve all impact the peg. A strong dollar or tighter Fed policies could put pressure on Hong Kong’s economy and the peg.
3. Reserves and Capital Outflows: While the HKMA has substantial reserves to defend the peg, prolonged or significant capital outflows from Hong Kong could potentially drain these reserves and put the peg at risk.
4. Changes in US-China Relations: Fluctuations in the relationship between the US and China also add to the uncertainty surrounding the HKD/USD peg. Some speculate that if the US imposes sanctions on Hong Kong, it could make it harder for the HKMA to defend the peg.

However, note that these are speculations, and the HKMA has repeatedly stated its commitment to maintaining the peg and has the financial resources to do so.

The peg has proven resilient in the past, surviving multiple crises, including the Asian financial crisis and the global financial crisis.

The Economics of Foreign Exchange

FAQs – What Causes a Currency Peg to Break?

What is a currency peg?

A currency peg is a policy where a country’s central bank maintains its currency’s value at a fixed rate or range to another currency or a basket of currencies.

This policy is implemented to stabilize exchange rates, control inflation, and foster trade and economic predictability.

What causes a currency peg to break?

A currency peg can break or fail when a country can no longer maintain its fixed exchange rate.

This often occurs when the country runs out of foreign exchange reserves or is on pace to – unless the currency is let go, which is much more prudent than running out of savings.

Other factors can include high interest rates, economic instability, and lack of investor confidence.

How do foreign exchange reserves influence a currency peg?

Foreign exchange reserves are critical in maintaining a currency peg.

Central banks use these reserves to buy and sell their own currency on the foreign exchange market to keep its value consistent.

When a central bank runs low on these reserves and can no longer intervene in the market to maintain the peg, it might be forced to devalue or float its currency, effectively breaking the peg.

How do interest rates affect a currency peg?

Interest rates are a tool used by central banks to control inflation and stabilize the economy.

Higher interest rates can attract foreign investors seeking better returns, leading to an increase in the demand for the currency and strengthening the peg.

Conversely, lower interest rates may dissuade foreign investment, reducing demand for the currency and potentially causing the peg to break.

What is the role of capital controls in a currency peg?

Capital controls are measures taken by a government to limit the flow of foreign capital in and out of the domestic economy.

These can include taxes, tariffs, legislation, or volume restrictions.

By managing capital flow, a country can maintain a stable currency and prevent sudden outflows that could threaten the currency peg.

However, if investors lose confidence and capital controls are not effective enough to prevent large-scale capital outflows, the currency peg can break.

Can political or economic instability cause a currency peg to break?

Yes, political or economic instability can contribute to a currency peg breaking.

Such instabilities can decrease investor confidence, leading to reduced demand for the currency and increased selling pressure.

This can deplete foreign reserves quickly as the central bank tries to maintain the peg, eventually leading to its failure.

What happens when the peg strengthens?

When a currency peg strengthens, the domestic currency becomes more valuable compared to the pegged currency or basket of currencies.

This situation often arises from high demand for the domestic currency.

As a result, the country’s central bank may seize this opportunity to accumulate FX reserves by selling more of its own currency in exchange for foreign currency.

Consequently, these FX reserves can later be used to intervene in the foreign exchange market to maintain the peg when needed.

Can a country re-establish a currency peg after it breaks?

Re-establishing a currency peg after it breaks is technically possible, but it would require substantial foreign exchange reserves and a stable economic environment to restore investor confidence.

Also, re-establishing a peg might not always be the best course of action, depending on the specific economic conditions and challenges facing the country.

It’s more likely for countries to re-peg the currency.

How does a country prevent a currency peg from breaking?

A country can prevent a currency peg from breaking by maintaining sufficient foreign exchange reserves, managing interest rates effectively, and implementing efficient capital controls.

Additionally, fostering a stable political and economic environment can help maintain investor confidence and demand for the currency.

However, even with these measures, external economic shocks or systemic economic imbalances can still threaten the peg.

How does breaking a currency peg impact the economy?

When a currency peg breaks, there can be a sharp depreciation in the currency’s value, leading to inflation and increased import costs.

Additionally, it could lead to a loss of investor confidence, potentially causing capital flight.

However, it can also provide an opportunity for the economy to readjust and rebuild based on market forces, which could be beneficial in the long run.

Conclusion

A currency peg is a valuable tool for maintaining economic stability.

However, various factors such as economic instability, market speculation, exhaustion of foreign exchange reserves, political instability, and high inflation can put stress on the peg, leading to its collapse.

Understanding these dynamics is important for investors, traders, and policymakers, as the breaking of a currency peg can have significant economic implications both domestically and globally.