You must have seen that most of the currencies are always pegged to US Dollar for trading. Have you ever wondered why this is done? Why is US dollar considered to most of the exchange rates? Well, in the below article you’ll find the reason why most of the countries choose to peg their exchange rate with the US dollars.
Pegging of currencies will help a smooth flow of trading without limiting to uncertainties like inflation and interest rates. It all started in the early 1970s when Bretton Wood Fixed Exchange system was collapsed. Until around 1970 majority of the currencies were in form pegged to US Dollars while US dollars itself was fixed to gold. The meltdown of Bretton Wood Exchange system started in 1967 when British pound led to 14.3% decrease in its value. President Richard Nixon then unilaterally terminated the gold standard.
In 1971 governments begin to float their own currencies. Since then we have 2 types of currency exchange rates: 1) Floating currency (USD, Euro, Japanese Yan) 2) Fixed currency
There are various reasons why a country’s currency is pegged to US Dollar. Countries such as India, Bahamas, Bermuda, Philippines etc is pegged with USD because the major source of income is derived from out-sourced IT services from US and Tourism is paid in Dollars. Fixing to the USD makes their country’s currency less volatile and stabilizes their economy.
Middle East countries such as Oman, Jordan, Saudi Arabia, Qatar, and UAE is pegged to USD because their major importer of oil is the United States. One of the major reason why USD is considered is that of the primary source of income of the country which would help their economy to stabilize and with-stand the volatility. While some of the small nations would peg their currency to the large nation’s currency this will enable them to expose their own currency to the same kind of risks that the larger nation faces.
What makes the value of a currency decrease?
Governments always maintain a fixed reserve of foreign currencies in order to maintain fixed exchange rate by trading (Buying or selling) its own currency to the open market. If the exchange rate drifts above the benchmark rate then the government will sell out its own currency to buy the foreign currency this will decrease the value of that currency. If they have bought the foreign currency which they pegged their currency with, it will increase the value of the pegged currency.
If the exchange rate drifts below the benchmark rate than the government buys its own currency by selling it own reserves. This will help the local currency to become stronger and back to the intended value. Under this, the central bank will set a fixed exchange rate for the currency then agrees to trade the currency at the set value.
Example: If India wants to peg its currency to USD, it wants the INR value to move at the same rate as the USD. If the INR value falls to the USD, India uses its foreign currency such as GBP or Euros to buy INR which adds up the valuation of the INR as demand increases with few INR in circulation in the market.
India can also sell INR if their value raises to the USD to increase the supply until their value equals to the USD.