eli5 How does a country become eligible to peg their currency to USD?
In: 8
There’s no eligibility criteria. They just unilaterally decide to do it. It’s as simple as a country saying, “one unit of our currency is equal to 1 US dollar” or whatever exchange rate they set. Not having an actual market in their currency where its exchange rate is determined by market participants could have bad economic and pricing impacts locally. But that has no bearing on whether a country can set an exchange rate pegged to any currency it wants to.
You don’t need to be eligible, any country is allowed to peg to any currency. To make a pegged currency you need a large amount of reserves of the currency you are pegging to because the currency price is still determined by the free market. To keep a currency pegged at a certain price the central bank needs to sell more of its currency if the price is too high and buy back its currency with the foreign reserves to raise the price.
Functionally to be really pegged 1:1 the country would need to have an equal amount of dollars in their ‘account’. In reality this concept is applied fractionally like 1 dollar equals X local currency. And developing countries usually keep a large reserve of US dollars for this exact reason. Having a lot dollars make your own currency valuable it’s like gold because you know there’s always a demand for dollars
Context I worked in currency derivative desks and also this concept is complicated so this is dumbed down
The central bank of that country just announces that they will exchange X of the local currency for 1 USD, and they will also exchange 1 USD for X of the local currency. Then the currency is pegged to the US dollar.
Of course, for the peg to last, the central bank needs either enough USD to cover those deals, or a way to borrow enough USD to cover them. The central bank can always print (or electronically create) the local currency, so conversions from USD are always fine, it’s the conversion to USD that can cause problems.
E.g. (simplifying a lot) under the ERM, the British pound was pegged to the Euro. Someone borrowed a billion pounds, and converted it to Euros. Seeing what was about to happen, other people converted pounds to Euros too. The UK central bank promptly ran out of Euros, so the UK had to cancel the peg and leave the ERM. This made the pound worth a lot less. So the person converted some of their Euros to the now cheaper pounds, and had enough pounds to pay off the loan with interest, while still having a lot of Euros left as profit.
The safest way is to ensure that the central bank actually has 1 USD for each X of the local currency that exists.
Another safe way is if two countries agree to peg their currencies together, in that case the two central banks can work together, and between them they can print both currencies.
Another approach is capital controls, making it illegal to transfer the local currency out of the country or to convert too much money into USD. That is not a free market solution, and generally considered a bad idea. Foreign people and companies won’t invest in your country if they can’t get their money back.
Latest Answers