Exploring the Blessings and Curses of Dollar Pegs for Developing Nations

Introduction:

In the global era of international industrialization and global trade among different economies, there is a
huge exchange of goods and services which leads to the formulation of exchange rate policies. Different
countries adopt different exchange rate policies based on their economic activities, unemployment rates,
market interest rates and gross domestic product. So, buckle up as we pave the way to understand and
explore the need, consequences and the reasons why developing nations adopt dollar pegs for their
exchange rate policies. As we navigate the intricacies of fixed exchange rates and their implications, we
aim to unravel the multifaceted impact on economic growth, monetary autonomy, and global trade.

Understanding exchange rate policies

These policies refer to the strategies and approaches which are adopted by governments or central banks
to manage and control the value of their national currency relative to other currencies when international
trade occurs among different global markets. These policies influence how exchange rates are determined
and can have significant implications for a country’s economy.

On broader terms, there are two kinds of exchange rate policies –

• Floating exchange rate – This exchange rate is determined by the changes in the foreign exchange market based on the supply and demand in the market
• Fixed / Pegged exchange rate – A fixed exchange rate is considered when a country’s currency is fixed or pegged to the value of currency of some major currency. When the currency of a country is pegged to U.S dollar, it is termed as dollar peg. For example: 1 USD = x Euro. So, we have to pay x euros in exchange of one USD.

How dollar peg works?

Let’s understand the working by an illustration. Imagine you have a special deal with a friend. You promise
to trade your toys for their candies at a fixed rate – let’s say three toys for one candy. This is a bit like what
some countries do with the U.S. dollar.

In this case, your friend is the country, and the U.S. dollar is like your toys. The country’s central bank
promises to give you a fixed amount of its currency for one U.S. dollar. But here’s the catch: the country
needs to have a lot of U.S. dollars to keep this promise.

Why? Well, most countries using a U.S. dollar peg have a lot of business with the United States. Their
companies sell stuff there and get paid in dollars. So, to pay their workers and local suppliers, these
companies exchange those dollars for the country’s own currency.

Now, here’s where it gets interesting. The country’s central bank takes those dollars and invests them in
something called U.S. treasures. It’s like putting the dollars in a piggy bank that earns interest. If the central
bank needs cash to pay its companies, it can sell some of those treasures.

But what if the value of the country’s currency falls too much compared to the dollar? The central bank
needs to fix it. So, it sells some of those treasures on the market. This lowers the value of the dollars in
the market, making the country’s currency stronger. It’s like adjusting the trade – getting a fair deal for
the toys and candies again.

However, it’s not easy to keep everything perfectly equal because the value of the U.S. dollar is always
changing. That’s why some countries don’t aim for an exact rate but instead have a range. It’s a bit like
haggling with your friend – sometimes you might get two toys for one candy or vice versa, but you both
agree it’s a fair trade. And that’s how some countries manage their currencies with a dollar peg!

Blessings of dollar pegs:

A dollar peg is when a country maintains its currency’s value at a fixed exchange rate to the U.S. Dollar.
As per the reports, it is found that 22 countries have dollar pegged exchange rate policies by the year 2022
and about 66 countries either have U.S.D as their legal tender or have dollar pegged. A common similarity
is also identified between developing nations that generally they tend to adopt dollar pegged exchange
rate policies.

So, let’s delve deep into the developing nations that why do they prefer Dollar pegs and what are the
potential benefits?

• Most of the international trade and financial transactions occur in U.S.D. Furthermore, most of the countries which are trade-reliant also prefer to trade in U.S.D. For example – Singapore, Malaysia, Honkong, etc. These reasons make it easy for pegged countries to expand their trade worldwide and boost their income sources.
• Since, U.S.D are given the status of currency reserve, it becomes easy for the traders to make long-term investments realistic. It is because there are lesser currency fluctuations and hence they foresee less long term changes because of which the risk and speculation involved in the investment is reduced. A predictable economic environment is created which reduces volatility and thereby increases the exchange rate stability. This fosters a nation’s economic growth, confidence and also the long term planning involved in the business and trading.
• With the historical precedencies, it has been found that there are very lesser or low inflation rates in the price of dollar. This leads to price stability in the market which enhances the consumer purchasing power.
• A fixed exchange rate simplifies international trade transactions, reducing currency-related risks for businesses. Without exchange rate risk and tariffs, individuals, businesses, and nations are free to benefit fully from specialization and exchange. Dollar pegs streamline cross-border trade, promoting export growth and facilitating foreign exchange reserves accumulation
• With lesser fluctuations in dollar values and due to the fixed peg policies, there is reduction in the disruptions to the supply chain.

Consequently, all of these factors contribute to foster the trade, reduce uncertainty and boost economies
and hence the overall growth of developing nations.

You can also read : How the Fed Rate Announcement Influences Savings Account Returns?

Curses of dollar pegs:

Though dollar pegs have a lot of benefits for developing nations but when the coin is flipped to other side,
it’s observed that dollar pegs often lead to loss of a developing nation too. Let’s discuss these curses step
by step:

• Developing nations often face challenges due to their limited control over monetary policy under a dollar peg. This policy limits the central bank’s ability to adjust the interest rates for economic growth and this lack of autonomy can hinder their ability to respond effectively to changing economic conditions.
• When the nations are pegged against U.S.Dollar , immediate change in the economic conditions in U.S. directly influences the pegged currency which exposes the developing nations to external economic shocks.
• The inability to adjust the exchange rate in response to economic imbalances and external shocks poses a significant challenge. Dollar pegs limit the flexibility needed to address trade deficits or surpluses, potentially leading to prolonged economic challenges.
• When too many people want to buy or sell the currency all at once, it causes problems. To handle this, the central bank keeps a stash of foreign money, like dollars, just in case. This helps them balance things out and keep the money stable. But if there’s too much buying or selling, the central bank ends up using a lot of its stash, which becomes a challenge.
• Over time, a dollar-pegged currency can become overvalued, which can impact the competitiveness of a nation’s exports. This situation can lead to a decline in market share and global competitiveness for the country’s products.
• If the country’s currency is tied too low to another currency, like the Chinese yuan being pegged too low against the U.S. dollar, it means people in that China find it harder to buy things from other countries. For example – if we have less power in our money, we’ll have to spend more of it to get things from abroad. On the flip side, the sellers of these foreign goods also notice a drop in people wanting their products. This can lead to business losses for them.

Now, if the country’s currency is pegged too high, people might go on a shopping spree for
imports, creating a constant demand. This can lead to a trade deficit, putting pressure on the
country’s currency. This can lead to a situation where the currency peg may collapse and when a
peg collapses, the country faces a ripple effect. Imports become pricier, leading to inflation.
Managing debts becomes tough. On the flip side, the other country in this scenario sees its
exporters losing markets and investors losing money on foreign assets.
This situation rose in Argentina in 2002 and also in 1992 when the British pound pegged to the
German mark.

So, these are the major disadvantages of adopting a pegged exchange rate policy for a developing nation.

Conclusion:

In the complex world of international finance, the choices developing nations make regarding their
currency pegs bear both promises and perils. As we have discussed above, these blessings come hand-in hand with potential curses that can impact the economic trajectory of nations striving for growth.

On the brighter side, a dollar pegs provide a developing nation with:

1. A stable environment for economic activities
2. Predictable and stable exchange rates
3. Attracts foreign investments
4. Makes cross-border transactions smoother and more accessible
5. Low inflation rates

Yet, the path of dollar pegs is not without its challenges. Nations embracing this strategy find themselves
in a delicate dance, surrendering some control over their monetary policies. It also leads to:

1. Alignment with U.S. economic conditions
2. Vulnerability
3. Expose developing countries to external shocks
4. Limits a pegged nation’s ability to adjust to changing economic landscapes

As we wrap up, we find that the success lies in a balanced approach. Developing nations must weigh the
benefits and drawbacks carefully, embracing resilience and adaptability in their economic strategies
because behind every exchange rate decision is the pursuit of prosperity for their people.

Therefore, thoughtful choices should be made by an economy by taking into consideration all the major
factors for the economic growth of a developing nation.