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WHILE currency pegs to the US dollar (i e, a fixed or linked exchange rate system) can bring benefits such as exchange rate stability and ease of international trade, they also come with significant risks, particularly in the context of increased volatility in globalisation.
The following are the main risks and case studies:
l Loss of Monetary Policy Independence
Risks: According to the ‘impossible triangle’ theory, under a fixed exchange rate system, the country needs to sacrifice monetary policy autonomy. If the Fed adjusts interest rates, the linked countries will be forced to follow suit, possibly in conflict with their domestic economic needs.
Case in point: When the Fed raised interest rates in 2015, Hong Kong had to raise rates in parallel because of the peg, putting pressure on the property market and stock market even though local economic growth had slowed.
l External shock conduction risk
Risk: Fluctuations in the US economy are directly transmitted to the countries linked through the exchange rate. For example, a stronger dollar weakens the export competitiveness of a linked country, or a loose dollar policy triggers capital inflows into emerging market bubbles.
Cases: The US Federal Reserve’s quantitative easing in 2020 led to a large amount of hot money flowing into emerging markets, but capital flowed back quickly after the aggressive interest rate increase in 2022, triggering foreign exchange crises in countries such as Sri Lanka.
l Foreign reserve pressure and liquidity crisis
Risk: Maintaining a fixed exchange rate would consume foreign exchange reserves. If the market sells its own currency, the central bank needs to continue to sell US dollars to intervene, and the depletion of reserves could lead to a collapse of the exchange rate.
Case: During the 1997 Asian financial crisis, Thailand abandoned the peg of the Thai baht to the US dollar due to insufficient foreign exchange reserves, triggering a currency collapse and economic recession.
l Input inflation/deflation
Risk: The fluctuation of the US dollar affects import costs in linked countries. A weaker dollar pushes up import inflation, while a stronger dollar could exacerbate deflation.
Case: The dollar strengthened in 2022, and the cost of imported energy and food in dollar-pegged countries such as Egypt soared, adding to domestic inflationary pressures.
l Volatility in capital flows
Risks: A fixed exchange rate attracts arbitrage capital, but capital flight accelerates when confidence falters, creating a ‘self-fulfilling’ currency crisis.
Case: In the 1994 Mexican peso crisis, capital outflows led to a sharp reduction in foreign exchange reserves and the government was forced to devalue the currency, triggering a chain reaction in Latin American markets.
l Speculative attacks and a crisis of trust
Risk: If economic fundamentals deteriorate (e g, trade deficits, high foreign debt), speculators may short the local currency, forcing the central bank to deplete its reserves.
Case: In 1992, when Soros struck the pound, Britain was forced out of the European Exchange Rate Mechanism because it could not maintain its exchange rate, and the pound plunged 15 per cent in one day.
l Long-term distortions in the economic structure
Risks: Exchange rate rigidity could mask competitiveness problems, leading to lagging industrial upgrading or trade imbalances.
Case: China’s long-term peg to the US dollar in the early 2000s boosted exports, but it also accumulated huge foreign exchange reserves and a trade surplus, and faced structural adjustment pressures.
l Geopolitical involvement
Risk: US policies (e g, sanctions, weaponisation of the dollar) may indirectly limit the ability of linked countries to transact internationally.
Case: Iran has difficulty using US dollar settlement due to US sanctions, and has been forced to switch to barter trade or local currency settlement, which has severely damaged its economy.
l Risk Response Strategies
Foreign reserve adequacy: Maintain high reserves in response to market intervention (e g, Singapore’s reserve management).
Exchange rate mechanism flexibility: Using managed floating exchange rates (e g India, Brazil) or a basket of currencies pegged (e g Saudi Arabia partially decoupling from the US dollar).
Capital flow controls: Temporary restrictions on short-term capital flows (e g Malaysia’s measures during the Asian financial crisis).
Diversification of the economic structure: Less reliance on a single industry or market, and greater resilience (e g the UAE promotes a non-oil economy).
Regional monetary co-operation: Risk sharing through regional agreements (such as the Asean Chiang Mai Initiative).
l Conclusions
The pros and cons of a currency peg to the US dollar need to be dynamically weighed. In a context of increased uncertainty about globalisation, excessive reliance on the anchoring of the single currency could amplify systemic risks. Countries need to choose exchange rate regimes flexibly in light of the economic structure, foreign exchange reserve levels and policy objectives, and gradually increase the flexibility to cushion external shocks when necessary.
Dong Liang
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