Currency Pegs and Managed Floats

Most currencies float — their price is whatever supply and demand say it is today. Some governments don't want that. Hong Kong has promised its dollar will trade within a narrow band of 7.75–7.85 per US dollar, full stop, and backs that promise with reserves. Others, like many emerging-market central banks, don't promise a fixed rate but regularly step into the market to smooth out moves they don't like. The line between "we will defend this exact rate" and "we will nudge things occasionally" is the line between a peg and a managed float, and it changes who bears the risk when the exchange rate wants to move.

How a peg is defended

To keep a currency from weakening past its promised level, a central bank sells foreign-currency reserves (usually dollars) and buys its own currency, directly absorbing the excess supply that would otherwise push the price down. This works as long as reserves last:

$$\text{reserves needed} \approx (\text{excess supply of local currency}) \times S_{peg}$$

In words: the central bank has to buy back roughly as much local currency as the market wants to sell, at the pegged rate, and every unit it buys costs one unit of its foreign-currency war chest. If the market keeps wanting to sell faster than reserves can absorb, the peg is arithmetically doomed — the only question is when, not if, it breaks.

Worked example

A central bank pegs its currency at 10 per dollar and holds $50 billion in reserves. Persistent capital outflows mean the market wants to sell the equivalent of $2 billion of local currency per month at that rate, forcing the bank to buy it all back with reserves to hold the peg. At that burn rate, reserves cover roughly 25 months (\50\text{bn} / $2\text{bn per month}$) before running out — but in practice speculators watch the reserve trend, and confidence usually collapses well before the arithmetic zero, triggering a sudden, much faster run as everyone tries to get out ahead of everyone else.

What this means in practice

A managed float gives a central bank flexibility and deniability — it can lean against a move without ever promising a level, so there's no specific line for speculators to attack. A hard peg gives certainty to trade and price contracts in, at the cost of a single point of failure: reserves. Traders who study a country's reserve trend, current account, and political will to raise rates in defense of the peg are effectively pricing how much longer the promise is credible — the subject of currency crises and speculative attacks.