Most of the currencies traders watch float freely, meaning their value is set by supply and demand in the foreign exchange market. Some do not. A number of countries tie their currency to another one, usually the US dollar or the euro, and promise to keep the exchange rate fixed or within a narrow range. That arrangement is called a currency peg.
How a peg works
A peg is a policy decision. The government or central bank announces a target exchange rate and commits to defending it. If the currency comes under pressure to weaken, the central bank buys its own currency using its reserves of foreign currency. If it comes under pressure to strengthen, it sells its own currency and builds up reserves.
Interest rates are part of the toolkit too. A country pegged to the dollar usually has to keep its interest rates close to those set by the US Federal Reserve. If it does not, money flows in or out in search of better returns and puts the peg under strain.
Some well-known examples
The Hong Kong dollar has been linked to the US dollar since 1983 and is kept within a narrow band. Saudi Arabia and several other Gulf states peg their currencies to the dollar, which makes sense when their main export, oil, is priced in dollars. Denmark keeps the krone closely tied to the euro.
Other countries use looser versions. Some manage their currency against a basket of trading partners. China sets a daily reference rate for the yuan and allows it to move within a band around that level, which is a managed system rather than a hard peg.
Why countries choose a peg
The main benefit is stability. A small, open economy that trades heavily with one partner can remove a big source of uncertainty for businesses and investors by fixing its exchange rate. A peg can also bring credibility, effectively borrowing the inflation discipline of a larger central bank.
The costs and risks
The price of a peg is independence. A country that ties itself to the dollar cannot set interest rates purely for its own economy. If the US raises rates while the pegged economy is weak, it may have to tighten anyway.
Pegs also need reserves. If markets start to doubt a central bank’s ability or willingness to defend the rate, speculators can bet against it, forcing the bank to spend reserves rapidly. If the reserves run low, the peg can break, often suddenly.
UK traders have a famous example close to home. In 1992 sterling was forced out of the European Exchange Rate Mechanism on what became known as Black Wednesday, despite heavy intervention and emergency rate rises. In 2015 the Swiss National Bank abruptly abandoned a cap it had placed on the franc’s strength against the euro, and the currency jumped in minutes.
Hard pegs and softer versions
Not every peg is equally rigid. A currency board, such as the system behind the Hong Kong dollar, backs every unit of local currency with foreign reserves and has very little discretion. A conventional peg relies more on the central bank’s judgement and willingness to intervene. A crawling peg allows the target rate to move gradually over time, often to account for higher inflation. The more discretion involved, the more room markets have to test the authorities’ resolve.
What a peg means for traders
A credible peg usually means very little day-to-day movement, so a pegged pair is not where most traders look for opportunity. The interest is in the edges. Watch for widening gaps between official and market rates, heavy reserve losses, rising interest rates in the pegged country, or political pressure. Those can be signs a peg is under strain.
Pegs also explain why some currencies follow the dollar or euro so closely. Understanding how interest rate expectations move FX helps make sense of the pressure points, and our guide to currency cross pairs shows how pegged and floating currencies interact.
The key lesson is that a peg is a promise, not a law of nature. It lasts as long as the country has the means and the will to keep it.
If you are building your understanding of FX and want to know where to focus next, our free trader assessment is a quick and useful starting point.
