Hard Peg

Understanding Hard Peg

Hard Peg is a term used to describe an exchange rate policy in which a currency is fixed at a specific rate against another currency. For example, the Chinese Yuan was pegged to the U.S. dollar at a fixed rate of 8.28 per dollar.

When a currency is pegged to another currency or a basket of currencies, it means that its value will fluctuate in the same proportion as those currencies. A hard peg allows for limited movement in relation to the pegged currency, creating a defined range known as a band.

Initially, currencies are often fixed at a specific exchange rate, but over time, they may be allowed to float freely based on market conditions. This typically happens when the government no longer wishes to maintain the peg due to economic or political reasons, or when it becomes unsustainable to support it.

Tether, a cryptocurrency that is pegged to the US dollar, serves as an example of a fiat-pegged cryptocurrency. Originally launched as RealCoin and later renamed Tether, the company claims that each unit of the token is backed by 1 US dollar held in reserve by Tether Limited. However, this claim has been subject to dispute.

One advantage of hard pegs is their simplicity and transparency. The supply of the cryptocurrency is fixed and known, making implementation easier without compromising transaction anonymity.

However, a disadvantage of hard pegs is the challenge of maintaining the peg if the currency is widely used as an actual currency rather than a commodity. If a large number of people purchase the currency, there may not be enough dollars held in reserve to back all issued Tethers. Similarly, if many people sell their holdings for dollars, maintaining the peg would also become difficult.

Currency pegging is a common practice where countries fix the value of their currency to that of another country. This is particularly prevalent in regions with significant trade, such as East Asia. It can also occur at a global level when a group of countries, like the European Union, agree to peg their currencies with each other.

Pegging a currency to another country’s currency offers several advantages:

1. Stability: By fixing the currency value, a country eliminates uncertainty about fluctuations in its money supply, providing stability. This is particularly beneficial for developing countries.

2. Effortless trade with other fixed-rate countries: When a country fixes its currency relative to another country, it no longer needs to devalue its own currency to negotiate better trade terms. The fixed currency rate already ensures favorable trade terms with the other country.

3. Lowering risk on capital investments and loans: Stable exchange rates eliminate the risk associated with fluctuating rates, making money supplies more predictable for businesses seeking to invest or borrow money in that country or region.