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!
In: 9007
I will try to explain this without talking to much about the particulars of Belize, because I don’t know much about Belize. Lets just make up a country called “B”
To explain pegging, it may be useful to explain why a nation may want to peg.
First, countries trade with other countries. Some more than others. In the case of small Latin American countries its possible they are entirely dependent on tourism and get all their income from tourists. In other places in the world (like Europe) its not about turisim but about bilateral border trade (between France and Germany for example). If a lot of the business is across the border its a real pain in the butt to have to keep converting currency back and forth. Imagine you live in the country B and go there every few months. With no currency control, the exchange rate is in a Free Float. The term “Floating” exchange rate, and specifically Free Float is the Opposite of a currency peg. This means, how much the “B’s” “Peso” (I just made that up) is worth is exactly whatever someone else will pay for it. One day its 1 USD = 0.23 BPS (made up), and the next day its 1 USD = 0.54 BPS. This is a total pain in the butt for you. You exchange your money and when you go back to the states you need to exchange back because you don’t want to hold onto BPS because it could be worth less next month. All this exchanging of money is really hard and expensive. It means you don’t even like to do business in this country because of the time and money to manage the exchange rate!
However, a Free Float is easy for a country to manage, they don’t manage it. It just works using a market.
Now, imagine you are running a small country B, that really really NEEDS trade with the US. You really don’t want to inconvenience tourists. You want them to come back again and again.
So, you can try to remove this inconvenience of a floating exchange rate, remove the uncertainty. To do this, you can do a lot of things. Some of them are harder than others. If your country B is really tightly tied to another country “USA” then maybe you could just decide to use the US Dollar. Like literally get rid of your currency. This is the ultimate “peg.” Its not really a peg, but its even more extreme than a Peg. A few countries have done this, its called “Dollarization.” The problem with doing this is you are totally married to the monetary policy of the US. IE, you don’t have ANY bank independence, you have no control over your currency, you gave it up. There are a lot of down-sides to this, but there is one big upside. Americans come and they can spend dollars and everything is in USD and everyone who is trading with you (if they live in USD) is very happy. Because of the down sides you may not be very happy, your people may feel like slaves to the US, you may get overthrown in a coup, and you may not be able to help your population in some circumstances.
So a currency Peg, to something like the USD is about as close to Dollarization as you can come without actually giving up all your monetary Independance. You are basically saying “Yeah, we are not USING dollars, but in practice its really close.” This gives you most of the benefits of dollarization without the complete loss of monetary policy.
The problem is, the Peg strategy takes a lot of work, and you MOSTLY loose monetary independence.
What is monetary independence? Well that is a big topic too. But fundamentally, its the ability to set an interest rate, and print money. That means when the US is in recession, you will likely have a recession too. And if the US has a recession, yours’s may be horrible.
To maintain a Peg, it means the government needs to maintain enough USDs to “defend” the currency peg. That means if everyone in B wants to suddenly leave and convert to dollars the B government better have enough. it DOES NOT mean that the government needs to have 1 for 1. Only enough to defend it. All the people of B will not be leaving for the US. Unless they do 🙂 And if the government doesn’t have enough money to defend the peg, then the exchange rate will have to change.
For really small governments, this means if there is pressure to defend the peg, its sometimes an environment where really rich people or institutions will come in to bet against the government and try to break the Peg – you can make money from this if you bet right. For very small countries and even medium ones this can be a big problem.
So maintaining a Peg is hard, and it requires a lot of fiscal dripline by the government of the country with the Peg. It means that maintaining the Peg may cause financial pain for the citizens of the country. To the point that they may have to be a poor country just to maintain this Peg. If B can only survive as a country with a Peg to USD, then that’s the way its going to be, then the people of B are going to suffer mightily if the US decides to raise interest rates, or otherwise remove the amount of USD in circulation.
So this is a long answer, and all of this is tied up with international politics, national self identity and how much one country wants to be tied to another country. In the end, defending the Peg is about a governments ability to force an exchange rate by buying currency for another currency at a fixed rate, and their ability to always do that when someone asks (which can get hard in some circumstances).
In the case of Balize, it looks like they have come as close to dollarization for tourism as they can without just dropping their currency. It looks like even keeping their currency is just an insurance policy incase the US does something really crazy they don’t like or cannot stomach. Its very hard to come back from dollarization once you do it. If you maintain a strong peg, and really let your economy be run by the US Fed then you can maintain it. But if things go crazy you could always break the peg and try something else. Once you give up your currency you basically cannot realistically get it back without even more pain.
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