Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Manage Currency Pegs Without Breaking Them
Transcript
- Lucas: Imagine you're a small country that trades heavily with a giant neighbor. Every time your currency fluctuates, your exporters panic, your import prices swing wildly, and your central bank has no anchor. That's why roughly a quarter of the world's economies choose to fix their exchange rate — they peg their currency to another, usually the US dollar or the euro. Luna: And the classic example that's held the longest? The Hong Kong dollar. Pegged to the US dollar since 1983. Lucas: Exactly — forty-three years and counting. The Hong Kong Monetary Authority maintains a narrow band of 7.75 to 7.85 Hong Kong dollars per US dollar. If the currency weakens beyond 7.85, the HKMA steps in and buys Hong Kong dollars with US dollars from its reserves. If it strengthens too much, they do the opposite. Luna: But that sounds like a central bank constantly intervening. Doesn't that drain reserves? Lucas: It can, which is why the HKMA holds a massive war chest. As of early 2026, their foreign exchange reserves are over 450 billion US dollars — one of the largest in the world relative to their economy. But the real mechanism is subtler. The peg works because the HKMA automatically adjusts interest rates to match the Fed. If the Fed raises rates and Hong Kong doesn't follow, capital flows out, the Hong Kong dollar weakens, and the HKMA has to drain liquidity to push rates up. Luna: So they effectively surrender monetary policy independence. They can't set rates for their own economy — they have to follow whatever the Fed does. Lucas: That's the trilemma in action. You cannot simultaneously have a fixed exchange rate, free capital movement, and independent monetary policy. You get to pick two. Hong Kong chose the fixed rate and free capital flows, which means monetary policy is outsourced to Washington. That worked fine when Hong Kong's economy moved in sync with the US. But when they diverge — like during the 2020s when China's slowdown dragged on Hong Kong while the US economy was booming — the peg creates tension. Luna: And when that tension breaks, you get what happened to the UK on Black Wednesday in 1992. The pound was in the European Exchange Rate Mechanism, pegged within a band against the Deutschmark. Lucas: Right. Britain had high inflation, the Bundesbank was raising rates to contain German reunification costs, and the Bank of England was forced to follow — even though the UK economy was in recession. Speculators like George Soros saw the contradiction and bet against the pound. The Bank of England spent billions of dollars in reserves trying to defend the peg, raised interest rates to 15 percent in one day, and still failed. On September 16, 1992, they withdrew from the ERM, and the pound fell 15 percent overnight. Luna: And Soros reportedly made over a billion dollars on that trade. But more importantly, the UK gained the ability to set its own interest rates — and they cut them almost immediately. The economy recovered. Lucas: That's the paradox of pegs. They can provide stability for decades, but when they break, they break violently. The Swiss National Bank learned that lesson in 2015. They had capped the franc at 1.20 per euro since 2011 to prevent deflation and protect exporters. But as the eurozone crisis eased and the European Central Bank launched quantitative easing, the franc kept appreciating. The SNB was printing francs to buy euros, and their balance sheet ballooned to nearly 80 percent of GDP. Luna: And then, without warning, they just dropped the cap in January 2015. The franc surged 30 percent in minutes. Companies like Swatch and ABB saw their export competitiveness shredded overnight. Lucas: The SNB's rationale was that the peg was no longer sustainable — the cost of maintaining it had become too high. But the way they did it, with no transition, destroyed trust. Markets assumed central banks with the credibility of the SNB would defend a peg at almost any cost. That assumption was wrong. And once credibility fractures, currency pegs become extremely expensive to defend because speculators know the central bank might blink. Luna: So what makes a peg credible? Is it just the size of reserves? Lucas: Reserves are part of it, but credibility is deeper. It's about whether the central bank's commitment aligns with the country's economic fundamentals. Hong Kong's peg works because its economy is highly dollarized — banks, contracts, and even salaries are often denominated in US dollars in practice. The peg isn't arbitrary; it reflects reality. Compare that to Argentina, which has attempted pegs or currency boards multiple times. Each time, the peso was overvalued relative to productivity, reserves ran out, and the peg collapsed. Luna: And there's also the political dimension. A peg can be seen as a policy anchor — a promise that the government won't print money recklessly. But if that promise gets broken, the loss of confidence can be catastrophic. Lucas: Exactly. The International Monetary Fund's research shows that pegged regimes tend to have lower inflation on average, but they also face more frequent and severe currency crises. The trilemma isn't just a neat theory — it's a binding constraint. Every central bank that runs a peg has to decide which of the three goals they're willing to sacrifice. Luna: And for listeners who are following along with the economics, understanding the trilemma is one of those lightbulb moments. If walking through the economy with us has made something click, we rely on listeners like you to keep this show going. Lucas: We deliberately don't run ads on these episodes. If you want to support that choice and help us keep the conversation independent, the link is buy me a coffee dot com slash fexingo. No pressure — just a way for those who find value to chip in. Luna: And we genuinely appreciate it. Now, back to pegs — one more case that's often overlooked: the Gulf states. Saudi Arabia, the UAE, Qatar, and others peg to the US dollar because their oil is priced in dollars. Lucas: Right. For them, the peg simplifies fiscal planning and trade. But it also means that when the US raises rates, Gulf central banks have to follow — even if their own economies aren't overheating. In 2025, the Fed held rates above 4 percent for most of the year, and the Saudi Arabian Monetary Authority had to match those hikes, which tightened domestic credit conditions even though Saudi inflation was modest. Luna: So the peg transmits US monetary policy directly to their economies. That can be uncomfortable when the US cycle is out of sync with local conditions. Lucas: Exactly. And that's why some countries choose a softer version — a crawling peg or a managed float. Singapore, for instance, manages the Singapore dollar against a basket of currencies, not a single one, and adjusts the slope of its appreciation path over time. They retain some monetary control while still providing predictability for trade. Luna: It's a more flexible approach, but it requires constant management and a lot of transparency. Otherwise, markets start guessing the central bank's next move and front-run it. Lucas: That's the key tension at the heart of any pegged system. The central bank is making a very visible promise. And if markets think that promise might be broken, they test it. The cost of defending a peg is a function of how much the market believes you'll sacrifice to keep it. Once that belief erodes, the cost becomes infinite — and the peg breaks. Luna: So the next time you hear about a currency crisis in the news, look at the trilemma. Chances are, the country was trying to have all three. Lucas: And the ones that survive — like Hong Kong — are the ones where the peg isn't just a policy choice but a structural fit. That's the real lesson. A peg only works if it's reflecting economic reality, not trying to impose it.