Why currency pegs crack
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A stablecoin called TerraUSD (UST) imploded this week, causing billions of dollars in losses and raising the question of why any cryptocurrency — or even a government-issued fiat currency, for that matter — would ever want to have its value pegged to some other currency.
Why it matters: Nowadays, most currencies float freely against each other. Historically, however, that's something of an anomaly. Indeed, as recently as 1971, even the U.S. was part of the Bretton Woods system that pegged all currencies to a gold standard.
The big picture: Pegs get introduced when market forces generate a level of volatility that makes planning and industry needlessly difficult.
- Countries implement pegs to ensure stable prices, both for their citizens and for any industries that export or import goods. Certainty and predictability are good things.
- Then, if the peg ends up too far from fundamentals, it can become harmful and brittle, and eventually break. In the case of UST, there were no fundamentals, so it was prone to break at any time. In the end, UST lasted less than 20 months.
A peg that's stood the test of time: The Hong Kong dollar weakened dramatically in the summer of 1983, causing panic selling of the currency, and panic buying of supermarket goods.
The solution: The local currency was pegged to the U.S. dollar at a rate of 7.8 to 1 on Oct. 13 of that year. It's stayed at that level ever since — more than 14,000 days and counting. (Since 2005, the exchange rate has been allowed to fluctuate within a narrow band, from 7.75 to 7.85.)
How it works: The Hong Kong Monetary Authority (HKMA) has a $466 billion Exchange Fund, which it uses to buy unlimited Hong Kong dollars at the 7.85 level. Conversely, the HKMA will sell unlimited Hong Kong dollars at 7.75.
- The dollar peg means that the HKMA can't set its own monetary policy. Whatever interest rate the Fed sets is perforce the overnight interest rate in Hong Kong, too.
The bottom line: It's highly improbable that financial speculators could break the Hong Kong peg. China's leadership, on the other hand, could do so at any time, if Sino-American relations deteriorate further.
