A currency peg works by having a country’s central bank commit to an announced exchange rate against another currency (or a basket) and then buying and selling in the foreign exchange market to keep the actual rate inside a narrow band around that target. The bank uses its stockpile of foreign reserves as ammunition: it sells reserves to prop the currency up when it weakens, and buys reserves to hold it down when it strengthens. Interest rates and, in some cases, capital controls back up the intervention. The peg holds as long as markets believe the central bank has both the resources and the will to keep defending it.
What a Peg Actually Commits the Central Bank To
A peg is a public promise about price. The central bank announces the rate it will maintain and the band it will tolerate around that rate, and it then stands ready to trade at those edges. Hong Kong’s Monetary Authority, for instance, keeps the Hong Kong dollar between HK$7.75 and HK$7.85 per U.S. dollar.1Hong Kong Monetary Authority. How Does the LERS Work Saudi Arabia has held the riyal at roughly 3.75 per U.S. dollar since the mid-1980s. Conventional pegs typically permit fluctuations of less than 1 percent around the target.2IMF. Classification of Exchange Rate Arrangements and Monetary Policy Frameworks
What the country gives up in exchange for that stability is monetary policy independence. Interest rates and money supply have to serve the exchange rate target first, which means they can’t be freely used to respond to domestic conditions like a recession or an inflation spike. That’s the deal a pegging country accepts.
Reserves: The Ammunition Behind the Promise
Before the peg is announced, the central bank has to build up foreign assets it can trade for its own currency when the rate comes under pressure. These reserves are usually held as U.S. Treasury bonds, euro-denominated bonds, gold, or IMF Special Drawing Rights, which are valued against a basket of the U.S. dollar, euro, Chinese yuan, Japanese yen, and British pound.3International Monetary Fund. SDR Valuation
How much is enough depends on the country’s exposures. The IMF uses a composite adequacy metric for emerging markets that weighs short-term debt, other portfolio liabilities, broad money, and export revenue, with heavier weights for countries running fixed exchange rates. Reserves in the range of 100 to 150 percent of that composite are considered broadly adequate for precautionary purposes.4International Monetary Fund. Measuring Reserves and Assessing Reserves Adequacy The strictest form of peg, a currency board, goes further: every unit of domestic money in circulation has to be fully backed by foreign assets at all times.
Reserve positions are public. The Bank for International Settlements notes that some central banks are required to publish financial statements monthly or even weekly, so investors and trading partners can judge whether the peg remains defensible.5Bank for International Settlements (BIS). Accountability, Transparency and Oversight When those reports show reserves shrinking faster than trade flows would explain, markets start to test the rate.
Day-to-Day Defense in the Market
Once the peg is live, the central bank’s trading desk works continuously to keep the exchange rate inside the band. The mechanics are symmetrical. If the domestic currency starts to strengthen past the upper limit, the bank sells its own currency and buys the anchor currency, which adds to reserves and increases the domestic money supply. If the currency weakens toward the lower limit, the bank does the opposite: it spends foreign reserves to buy back domestic currency, shrinking the money in circulation.
These trades are executed through open market operations, typically routed through primary dealers — large commercial banks authorized to transact directly with the central bank.6Federal Reserve Board. Open Market Operations Speed matters. Hesitation at the edge of the band signals weakness and invites more selling pressure.
Sterilized vs. Unsterilized Intervention
Every intervention has a side effect on the domestic money supply, and the central bank has to decide whether to accept that side effect or offset it. Buying foreign currency without any offsetting action floods cash into the banking system, pushing interest rates down and potentially adding to inflation. That’s unsterilized intervention: a combined exchange rate and monetary policy move in one.
Most central banks prefer to sterilize. After buying foreign currency, the bank sells domestic government bonds to pull the newly created money back out of circulation. The net effect on the money supply is zero, and the exchange rate still gets defended. The mechanism is subtler, working through the mix of domestic and foreign assets in private portfolios rather than through interest rates.7Danmarks Nationalbank. Sterilised and Non-Sterilised Intervention in the Foreign-Exchange Market Sustained sterilization can also get expensive, because the central bank earns low returns on its foreign bonds while paying higher rates on the domestic bonds it issues to soak up liquidity.
Interest Rate Adjustments
When direct intervention isn’t enough, the next tool is interest rates. Raising the overnight or discount rate makes domestic-currency deposits more attractive to foreign investors, increasing demand for the currency and supporting the peg. Cutting rates discourages capital inflows that would push the currency too strong. The catch is that the rate the peg needs may not be the rate the economy needs. A country in recession that has to raise rates to defend its peg faces an ugly choice between exchange rate stability and growth.
How Tightly the Peg Binds: Three Common Arrangements
Not every fixed rate works the same way. The IMF classifies pegged arrangements along a spectrum, and where a country sits on it determines how much of its monetary policy it has surrendered.2IMF. Classification of Exchange Rate Arrangements and Monetary Policy Frameworks
- A currency board is the strictest form. Legislation commits the country to exchange its currency for a specific foreign currency at a fixed rate, and every unit of domestic money in circulation has to be fully backed by foreign assets. Standard central bank tools like adjusting interest rates or acting as a lender of last resort are essentially off the table. Hong Kong operates this way.
- A conventional peg fixes the rate to another currency or a basket, with fluctuations kept under about 1 percent. The central bank still has its usual toolkit and can adjust rates and intervene, but monetary policy is constrained by the need to defend the target.
- A crawling peg is adjusted in small, preannounced increments, often tied to inflation differences between the pegging country and its major trading partners. The crawl can be backward-looking, based on past inflation, or forward-looking, set at a rate below projected inflation. The country gives up some certainty about the future exchange rate but avoids the pressure that builds up under a rigid target.
Capital Controls as a Backup
When open market operations and interest rate moves can’t absorb all the pressure, some countries restrict the flow of money across their borders. Direct controls include outright bans on certain cross-border transactions, approval requirements for moving capital abroad, and minimum holding periods for foreign investments. Market-based controls work through prices, such as taxing short-term inflows or imposing reserve requirements on foreign-currency deposits.8IMF (International Monetary Fund). Capital Controls: Country Experiences with Their Use and Liberalization
Controls buy time, but they carry costs. They discourage foreign investment, can create black markets for currency exchange, and are hard to remove once imposed. Countries that lean on them heavily often find the controls themselves eroding the confidence the peg was supposed to provide.
Why Pegs Break
A peg is a promise, and markets test it. A speculative attack happens when traders borrow large amounts of the pegged currency and sell it, betting that the central bank will run out of reserves before they run out of patience. The IMF describes an attack as “first and foremost an attack on the government’s accumulated international reserve stock and its access to international reserve credit.”9International Monetary Fund. Annex V: Economics of Speculative Attacks
A handful of signals tell traders a peg is vulnerable:
- Reserves are falling faster than trade deficits alone would explain, meaning the central bank is spending its ammunition on defense.
- Domestic short-term interest rates have climbed well above rates in the anchor-currency country, suggesting the bank is paying a steep price to hold money in.
- Fiscal and monetary policy have drifted out of line with the exchange rate target. The IMF notes that speculators pounce when exchange rate policy becomes inconsistent with fiscal or monetary policy.9International Monetary Fund. Annex V: Economics of Speculative Attacks
- Domestic inflation has run persistently higher than in the anchor country, making the pegged currency increasingly overpriced in real terms and hurting export competitiveness.
When enough of these signals appear together, the cost of defending the peg can go from expensive to impossible in days. The pattern in past collapses — Thailand’s baht in 1997, Argentina’s peso in 2001, the British pound leaving the European Exchange Rate Mechanism in 1992, and the Swiss franc’s floor in 2015 — is consistent: suppressed exchange rate volatility doesn’t vanish, it accumulates as economic imbalance, and the adjustment when it comes tends to be far more violent than gradual floating would have been. The BIS has noted that financial markets exert “a tremendous disciplining effect on central banks” in this regard.5Bank for International Settlements (BIS). Accountability, Transparency and Oversight
Deliberate Rate Changes vs. Forced Breaks
Not every change in a peg is a crisis. Countries sometimes carry out planned devaluations or revaluations when economic fundamentals have shifted enough that the old rate is no longer sustainable. Under the IMF’s Articles of Agreement, members must notify the Fund of their exchange rate arrangements and cooperate with it to promote orderly conditions.10International Monetary Fund. Article IV – Obligations Regarding Exchange Arrangements
The process typically starts with the central bank’s governing board reviewing updated projections and voting on a new target, with sign-off from the finance ministry or executive branch. The new rate is announced publicly and takes effect immediately, with commercial banks updating their systems and pending transfers settling at the new price. Framing matters: a devaluation presented as a measured recalibration can stabilize expectations, while one that looks like a panicked retreat invites more selling. Countries that adjust their pegs without adequate transparency can face higher borrowing costs or reduced access to IMF lending.
A crawling peg sidesteps much of this by building small, regular adjustments into the system from the start. Rather than defending one rate until it breaks, the exchange rate is allowed to drift with inflation differentials or other indicators, spreading out the adjustment that a rigid peg would eventually have to make all at once.