Dozens of countries use currencies which are pegged to the US dollar. Currencies which are pegged to the US dollar fall into 3 general categories: tourist economies (many Caribbean countries), trade economies (Hong Kong, oil-based Middle Eastern economies), and recovering economies (Argentina between 1991 and 2001). For recovering economies, the US-dollar peg is usually temporary, to provide temporary economic stability until the country can get its own economy and currency back on its feet.
Bretton Woods and the gold standard
Between 1870 and 1914, all currencies were pegged to gold, which indirectly pegged them to each other. However, trade imbalances could not be corrected easily, and extreme trade imbalances led to forced trade through aggressive economic and military actions, such as the Opium Wars.
The cost of World War I and II was the final straw to severely strained gold reserves in Great Britain and much of the rest of Europe. Many European nations had already transferred much of their gold reserves to the United States to back their debts, which made that gold unavailable to back their own currencies.
Establishing the stability of world currencies was essential to rebuilding the financial economic system after the Great Depression and World War II. Under the 1944 Bretton Woods system, all participating currencies were pegged to the US dollar, in its new role as world reserve currency. This system required participating countries to buy or sell US dollars to maintain their currencies within +/-1% of the defined level of parity.
Although the US dollar had effectively taken over the role of the gold standard for the rest of the world, the system still depended on the US itself retaining the gold standard. The US dollar was linked to gold at a fixed price of $35 per troy ounce. When Nixon terminated convertibility of the US dollar to gold on August 15, 1971, the Bretton Woods system came to an end. At that point, the US dollar became fiat currency, and the world’s currencies ceased to be linked to gold at all.
Considerations for a US dollar peg
Balance of trade is a primary consideration for all countries whose currency is pegged to the US dollar. Oil-based economies which peg their currencies to the US dollar do so because so much of the oil trade is conducted in US dollars.
Similarly, tourist-based economies which peg their currencies to the US dollar conduct a large part of their tourist trade in US dollars, and many domestic businesses may accept the US dollar as legal tender. Some island countries are so small that they have very little currency in circulation at all.
Pegging a country’s currency to the US dollar will cause the local currency to rise or fall with the US dollar. This will affect the cost of imports and the desirability of exports.
A fast rise in the value of the US dollar will increase the inflation in any pegged economy, which can cause that country to fall into recession. A sharp dive in the value of the US dollar will pull down other countries which have currencies pegged to the US dollar.
Cutting the peg
Several countries may be considering cutting ties with the US dollar for these reasons, especially after the financial crash of 2007. As well, other strong currencies, such as the euro, are now available as reserve currencies. Russia and Sudan are just a couple of many countries that are looking to shift from a US dollar peg to a euro peg.
For the first time ever, Saudi Arabia has not set its interest rates to match those set by the US Federal Reserve. This could be a signal that Saudi Arabia is preparing to separate its currency from the US dollar. If Saudi Arabia does separate the Saudi riyal from the US dollar, it could trigger a widespread selling off of US dollars, which would cause the value of the US dollar to plunge.