When is a currency pegged to another currency?

Answer 1

Countries try to stabilize their export competitiveness by living under a fixed exchange rate regime sometimes called a pegged currency or exchange rate. The central bank has to sell or buy its own currency to stabilize its external trading value against the currency of its trading partners.

China, also it unpegged its currency recently back in 2008, had for over 20 years a pegged currency to the US$. Since China had over many years a trade surplus it was buying US Treasury bonds in order to avoid that its currency would appreciate as a theory of purchasing power parity theory would predict.

This led to the fact that China is holding over 2,000 billion US$ worth of currency reserves right now, half of it denominated in US$.

Pegging a currency has advantages and disadvantages. The key advantages are that you can maintain your competitiveness in exports and reduce the overall risk of doing international business on the other hand a fast growing country has a hard time to constantly sterilize the influx of funds through trade and speculator while keeping interest rates artificially low. Which leads to asset bubbles that finally burst at some time in the future which will conexant periods of higher inflation followed buy a bust in equity markets or real estate. Another disadvantage is if countries do not have enough funds to defend their currency during a speculative attack if it is overvalued due to the fact that the currency is pegged. That leads to rapid depreciation and a deep recession, the last Asian crises from 1998 was a good example of that.