What is currency pegging and why are we hearing so much about it?
The Danish krone and the Swiss franc are both making headlines because of 'currency pegging'. With the franc causing havoc in January 2015 when it unpegged from the euro, and the krone possibly going the same way, we're getting used to seeing the term. But what exactly is currency pegging and why does it matter?
Currency pegging simply means establishing a fixed exchange rate between two currencies. Tying two economies together like this means that importers and exporters can rely on the rate, so the value of goods won't change according to market conditions. That's why countries will often peg their currencies to those of their trading partners, as Denmark did in the '80s with West Germany, their main one.
The major benefit of currency pegging is that it increases trade, hence why export-dominated economies are more likely to use it. Currencies that are too strong can threaten a country's trade prospects, as their products are too expensive to compete.
However, while it's good for economies in terms of trade, currency pegging can cause high levels of inflation. If a nation's currency gets stronger, it has to buy more of the currency it's pegged to in order to keep its value down, maintaining the fixed rate. The consequence is that the nation ends up with huge foreign reserves, increasing the amount of money in the system and ultimately pushing up prices.
So, why might Denmark have to unpeg its currency now? The European Central Bank's recent initiatives to bolster the eurozone's economy have decreased the euro's value. To maintain the fixed rate, Denmark will need to print more krone. But for Denmark, it might be an approach worth taking. With exports contributing to 50% of Denmark’s GDP, unpegging the krone could lead to mass unemployment. That's because a soar in its worth would mean Danish businesses couldn't match or undercut international competitors anymore.
That's why currency pegging matters. It impacts on the economic security of countries, in turn affecting employment, the cost of living and international investments in those nations. To see in real terms what the impact of the krone unpegging would be, take a look at our blog on how spending in Switzerland [LINK: SWISS FRANC BLOG] was hit after it made the same move.
