Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use Exchange Rate Pegs as Policy Tools
Transcript
- Lucas: Luna, I want to talk about a tool that most central banks don't actually use anymore — but the ones that do, it defines their entire existence. I'm talking about an exchange rate peg. Luna: Right, where a central bank promises to keep its currency at a fixed value against another, usually the US dollar. A lot of smaller economies have tried it, but it rarely ends well. Lucas: Exactly. And the classic example that's still running is Hong Kong. Since 1983, the Hong Kong dollar has been pegged at roughly 7.8 to one US dollar. That's over 40 years of a fixed rate. The Hong Kong Monetary Authority — the HKMA — has to hold enough US dollars to back every Hong Kong dollar in circulation. Luna: And they do. I think their foreign reserves are over $400 billion, which is huge for an economy their size. That's the core of it, right? You need a war chest to defend the peg. Lucas: War chest is the perfect phrase. Because if traders start betting that the peg will break — that the Hong Kong dollar will weaken — they'll sell it aggressively. The HKMA has to step in and buy its own currency with US dollars. If they run out of reserves, the peg collapses. Luna: That's basically what happened to Thailand in 1997 during the Asian Financial Crisis. They were trying to defend a peg to the dollar, but their reserves weren't deep enough. They eventually let it float, and the baht lost half its value. Lucas: Right. And that brings us to the policy trilemma — also known as the impossible trinity. A central bank cannot simultaneously have free capital flows, an independent monetary policy, and a fixed exchange rate. You have to pick two. Luna: So if you peg your currency, you give up control over interest rates. You're effectively importing the monetary policy of the country whose currency you're pegged to. Lucas: Exactly. When the Fed raises rates, the HKMA has to raise rates too, or investors will flee Hong Kong dollar assets for higher yields in US dollars. That's not a choice — it's a requirement if you want to keep the peg. So Hong Kong's interest rates basically track the Fed's, regardless of what the local economy needs. Luna: Which can be painful. If Hong Kong is in a recession but the US is booming and hiking rates, Hong Kong has to hike too, which deepens the downturn. That's the sacrifice. Lucas: Right. And the question is: why accept that trade-off? For Hong Kong, the answer is about credibility and stability. A fixed exchange rate removes currency risk for businesses and investors. It makes Hong Kong a reliable financial hub. The peg has been a cornerstone of its role as an international centre. Luna: And it's not just Hong Kong. Some oil-exporting Gulf states peg to the dollar for similar reasons — it stabilises their revenue, which is denominated in dollars. But even then, it's a constant commitment. Lucas: Let me give you a contrast. In 2022, Turkey's central bank under President Erdogan kept cutting interest rates despite inflation above 70 percent. That's the opposite of what you'd do with a peg. The lira was already floating, but the central bank was intervening heavily to slow its decline — effectively a soft peg. But because they refused to hike rates, they couldn't defend the currency. The lira lost more than 40 percent of its value against the dollar that year. Luna: And they burned through a huge chunk of their foreign reserves trying to defend it. It's a textbook case of the trilemma: they wanted low rates, a stable currency, and free capital flows. You can't have all three. Lucas: So a peg is a promise. And the only way to keep that promise is to subordinate your monetary policy entirely to the anchor currency. That's why most large economies — the US, the eurozone, Japan, the UK — let their currencies float. They value the flexibility to set interest rates for their own domestic conditions. Luna: But for a small, open economy with a lot of trade and investment in one currency, the peg can make sense. The key is having the reserves and the political will to maintain it. Lucas: And that political will is tested in moments of crisis. Look at Argentina. They've had multiple pegs and currency boards over the decades, and they've broken most of them. Each time, the trigger was a loss of confidence — people started to believe the peg wouldn't hold, and that belief became self-fulfilling. Luna: Because if everyone runs to convert pesos to dollars at the promised rate, the central bank runs out of dollars. It's a classic bank run, but for a whole country's currency. Lucas: Right. And that's why the strength of a peg isn't just about economics — it's about credibility. The HKMA has maintained its peg through the 1997 crisis, the 2008 global financial crisis, the 2019 protests, and COVID. Each time, they had the reserves and the determination to defend it. That track record is why investors still trust it. Luna: So if a listener is trying to understand the trade-off: a peg buys you stability and lower transaction costs, but you surrender your ability to set your own interest rates. And if you ever look like you're wavering, the market will punish you severely. Lucas: Exactly. And look, if this kind of breakdown of how central banks really work has been useful to you — if walking through the economics with us has made something click — these episodes stay ad-free because of listener support. You can help keep it going at buy me a coffee dot com slash fexingo. No pressure, just a heads up that that's how we keep the lights on. Luna: Yeah, it's a small way to say 'this is valuable to me,' and it really does make a difference. We're grateful for everyone who does. Lucas: Alright, back to the peg. One of the less discussed angles is how a peg affects the central bank's balance sheet. When the HKMA buys US dollars to maintain the peg, it creates Hong Kong dollars. That's a form of money creation. So the peg also determines the money supply. Luna: That's right. Under a currency board system — which Hong Kong essentially operates — every Hong Kong dollar in circulation must be backed by a US dollar in reserves. So the money supply is entirely demand-driven. If people want more Hong Kong dollars, they have to bring US dollars to the HKMA. The central bank can't just print money independently. Lucas: That's a huge constraint. It means the central bank can't act as a lender of last resort in its own currency without violating the peg — unless it has spare reserves. That's why some critics argue that currency boards are too rigid during financial crises. Luna: But the flip side is discipline. A government that's tempted to print money to finance spending can't do it under a currency board. That's why some countries adopt pegs as a commitment device — to force themselves to be fiscally responsible. Lucas: So a peg isn't just a monetary policy tool. It's a whole regime — a set of rules that constrain everything the central bank can do. And when it works, it provides remarkable stability. When it fails, the fallout is brutal. Luna: And the world today is actually seeing a resurgence of interest in this topic, especially in developing economies that are frustrated with dollar dominance. Some have floated the idea of a basket peg — tying to a mix of currencies rather than just the dollar. Lucas: That's an interesting development. China's renminbi is sometimes described as a managed float with reference to a basket of currencies, though it's not a hard peg. But it shows that the conversation about fixed versus floating is still very much alive. Luna: So for our listeners: the next time you hear about a country defending its currency, you'll know what's at stake. It's not just a number — it's a whole policy framework, with trade-offs that affect everyone in that economy. Lucas: Exactly. And if you want to dig deeper, the HKMA publishes a monthly report on its foreign reserves and the currency board operations. It's surprisingly readable and a great way to see this in real time. Luna: I'll have to check that out. Thanks, Lucas. Lucas: Thanks, Luna. That's it for today's episode. We'll see you next time.