What Is a Peg to the Dollar?

Why Countries "Peg" Their Currency to the Dollar

yuan peg to the dollar
China loosely pegs its currency, the yuan, to the dollar. Credit: PhotoAlto/James Hardy

Definition: A dollar peg is when a country keeps its currency's value at the same exchange rate to the U.S. dollar. That means the country's central bank intends to control the value of its currency so that it rises and falls as the dollar does. The dollar's value fluctuates because the United States and many other countries have a floating exchange rate

There are at least 66 countries that either peg their currency to the dollar or use the dollar as their own legal tender.

That's because the dollar is the world's reserve currency, a status it's had since the 1944 Bretton Woods Agreement. The next runner up, the euro, has 25 countries that peg their currency to it in addition to the 17 eurozone members. 

How Does a Dollar Peg Work?

A dollar peg uses a fixed exchange rate. That means the country's central bank promises it will give you a fixed amount of its currency in return for a U.S. dollar. To maintain this peg, the country must have lots of dollars on hand. That's why most of the countries that peg their currencies to the dollar have a lot of exports to the United States. Their companies receive lots of dollar payments. They exchange those for local currency to pay their workers and domestic suppliers.

Central banks usually use these dollars to purchase U.S. Treasuries. That way, they receive at least some interest on their dollar holdings. If they need to raise cash to pay their companies, they'll sell Treasuries on the secondary market.

A country's finance minister will monitor his country's currency exchange rate relative to the dollar's value. If the currency falls below the peg, he needs to raise its value and lower the dollar's value. He does this by selling Treasuries, putting more of them on the secondary market. He uses the cash received to purchase local currency.

That adds to the supply of Treasuries, lowering their value which then lowers the value of the dollar. It reduces the supply of local currency, raising its value and restoring the peg.  

Keeping this exact amount is difficult, since the dollar's value changes constantly. That's why some countries peg their currency's value to a dollar range instead of a specific number.

China uses a fixed exchange rate, as opposed to the That's because it prefers to keep its currency low to make its exports more competitive. In fact, every country tries to do this, but few have China's ability to keep it fixed. For more, see Currency Wars.

China's currency power comes from its exports to America, mostly consumer electronics, clothing and machinery. In addition, many U.S.-based companies send raw materials to Chinese factories for cheap assembly. The finished goods become imports when they are shipped back to the United States. For more, see U.S. Trade Deficit With China.

As a result, Chinese companies receive dollars as payments for these goods and services. They deposit the dollars into their banks in exchange for yuan to pay their workers. Banks send the dollars to China's central bank, which stockpiles them in its foreign currency reserves.

This reduces the supply of dollars available for trade. That puts upward pressure on the dollar. For more, see Dollar Value.

China's central bank also uses the dollars to purchase U.S. Treasuries. It needs to invest its dollar stockpile into something safe that also gives a return, and there's nothing safer than Treasuries. China knows this will also further strengthens the dollar, lowering the yuan's value. For more, see U.S. Debt to China

Why Do Countries Peg Their Currency to the Dollar

As mentioned earlier, the U.S. dollar is the world's reserve currency, so this is one reason that countries peg to it. That means that most financial transactions and international trade is done in U.S. dollars. Countries that are heavily reliant on their financial sector, Hong Kong, Malaysia and Singapore, peg their currencies to the dollar.

 

Other countries that export a lot to the United States, such as China, pegs its currency (the yuan) to the dollar to maintain competitive pricing. It tries to keep the value of their currency lower than the dollar. This gives it a comparative advantage by making its exports to America cheaper.  For more, see How Does China Influence the U.S. Dollar?

This is different from Japan, which doesn't exactly peg the yen to the dollar. However, it does try to keep the yen low compared to the dollar because it exports so much to the United States. Like China, it receives a lot of dollars in return. The Bank of Japan uses those to become the fourth largest purchaser of U.S. Treasuries for that reason.

Other countries, like the oil-exporting nations in the Gulf Cooperation Council, must peg their currency to the dollar because their primary export, oil, is sold in dollars. As a result, they became large owners of dollars in their sovereign wealth funds. These petrodollars are often invested in the United States to earn a greater return. For example, Abu Dhabi invested petrodollars in Citigroup to prevent its bankruptcy in 2008. 

Countries that do a lot of trading with China or oil-exporting countries will also peg their currency to the dollar.