I’m currently in Belize, where the local currency (the Belize Dollar) is “pegged” to the US dollar, with 1 Belize Dollar always being worth $0.50 USD. I also heard that the Guatemalan Quetzal was pegged to the dollar in the 20th century, but isn’t any more.
How does this work? Does this mean that Belize Dollars are functionally US dollars in the global economy? And there must be implications for how much money a pegged country could print without losing its value…I could use an overview!
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It means that the value of the Belize dollar is effectively set to be $0.50 of the dollar. Belize has a reserve of US dollars that represents $0.50 of the Belize dollars in the world. For example if Belize wants to add(print) 1 Belize dollar it needs to buy an additional $0.50 in USD to match. It works much like the gold reserve system used to in the US.
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It works similar to old gold or silver standards, the central bank promises to pay you in dollars for their notes in the same way that currencies would get you a certain amount of gold when they were on the gold standard. It means that a smaller country like Belize is less vunerable to market forces, they ‘borrow’ stability from the US, but it also means they can’t act so easily to deflate or inflate their currency as suits their economy. They need to have a considerable fund of US dollars for it to work but not actually 1 for every 2 Belize dollars
There’s three main ways:
– Having enough of that currency to exchange (as others have said), much like a gold standard. This works great if you can afford to buy enough currency for the currency you’re pegging to.
– Manipulating the price on the market to keep it roughly in line. This involves adjusting your interest rates plus buying and selling currency to keep it in line. So long as everyone thinks the peg will work, this works okay. Once the markets get a whiff that it’s going to collapse, they “bet” that the currency peg will fail by buying or selling your currency, the peg most likely falls apart, and your central bank is out a lot of money. This happened to the UK when it crashed out of the ERM.
– Declaring it to be so and the arresting anyone in the country who does otherwise. This one doesn’t work, generates a huge black market, and basically means one of the currencies stops being used. Still, some countries do try it.
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I’m sure you have the basics now. But if a country runs out of US dollars (maybe because they run a trade deficit so more dollars leave then enter) then they can no longer support the currency and a economic crash will happen.
Also if the peg is not “fair” then a black market will emerge for the currency. So 100 USD will get you 500 on the streets rather then the 200 from the central bank. This is bad for the bank because it means they don’t get the likely much needed USD they can use to prop up the currency and because who wants a black market to emerge anyways. So if inflation runs rampant and they don’t adjust the peg then that will happen and it’s basically one of the problems in Lebanon.
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