How a currency peg is defended
A peg promises that a unit of local currency can be exchanged for a set amount of a stronger currency. To make that promise believable, a central bank must be ready to trade at the stated rate. If people and businesses want to exchange local money for more foreign currency than private markets supply, the bank can sell foreign-currency reserves and buy local currency, supporting its price.
Those reserves are finite. A shock—such as a fall in export earnings or a rush to move money abroad—can sharply increase demand for foreign currency. Each intervention uses more of the bank’s stock, and traders may become less willing to accept the peg if they doubt the bank can keep paying out.
The cost of holding the line
A government can try to slow the drain by raising interest rates, making local assets more attractive and borrowing more expensive. But higher rates can also squeeze households and businesses, while restrictions on currency trading may disrupt commerce. Defending the exchange rate can therefore mean accepting economic pain before the reserves are exhausted.
If officials can no longer maintain the rate, they may devalue the currency—reset its official value—or abandon the peg and let its price move more freely. Imported goods can then cost more in local money, especially when the country relies on foreign supplies. The peg’s stability was never free: it depended on having enough reserves, and enough willingness to bear the costs, to make the promised exchange rate real.
