Currency Intervention: How Central Banks Defend a Peg

Central banks intervene in currency markets by buying or selling foreign reserves to support a pegged exchange rate. A sterilised intervention offsets the money-supply impact by selling bonds; an unsterilised intervention allows the money supply to expand or contract. Swap lines with other central banks and forward contracts extend the toolkit. Yet all defenses have limits: when capital flight exceeds reserves, pegs break.

The Core Mechanic: Buying and Selling Reserves

A central bank defends a peg by stepping into the currency market as a buyer or seller. If the local currency is under pressure (appreciating beyond the target band), the central bank sells local currency and buys foreign reserves, injecting supply. If the local currency is weakening (falling below the band), the central bank buys local currency by selling foreign reserves, absorbing excess supply.

The effectiveness of intervention depends on having enough reserves to absorb the pressure. A small central bank with $2 billion in reserves cannot defend a peg against $10 billion in daily speculative selling.

Sterilised Intervention: Preserving the Money Supply

A sterilised intervention decouples the exchange-rate defense from monetary policy. When the central bank buys foreign currency (injecting local currency into the money supply), it simultaneously sells an equivalent amount of domestic bonds, mopping up that money. The result: the peg is defended without changing the money supply.

Example:

• Domestic currency is weak; the central bank buys it with foreign reserves.
• This removes local currency from the market and strengthens it.
• But buying local currency injects foreign currency, expanding the monetary base.
• To sterilise, the central bank sells bonds, pulling local currency back out.
• Net effect: the peg is defended, and money supply is unchanged.

Sterilised intervention works best when underlying interest-rate differentials are small or when the pressure is short-lived. It is also less politically controversial because it does not force the central bank to tighten or loosen monetary policy against its chosen path.

However, sterilised intervention has limits. If the central bank must continuously drain local currency via bond sales, interest rates rise, attracting more foreign capital flows and defeating the purpose. Over time, repeated sterilisation becomes unsustainable.

Unsterilised Intervention: Tightening or Easing

An unsterilised intervention directly links the currency defense to the money supply. If the central bank buys local currency to support the peg, it is also withdrawing money from the economy, tightening monetary policy. If it sells local currency to prevent overappreciation, it is expanding the money supply.

Example:

• The local currency is depreciating; the central bank buys it using foreign reserves.
• This reduces the monetary base (less local currency in circulation).
• The economy tightens, and interest rates rise.
• Higher rates attract foreign capital inflows, supporting the peg.

Unsterilised intervention forces the central bank to choose between the peg and domestic monetary policy. Defending a collapsing peg via unsterilised intervention may require severe tightening—high interest rates, reduced credit—that harms growth. This is why pegs often break: the political cost of defense becomes intolerable.

Swap Lines and Borrowed Reserves

When a central bank’s own reserves run low, it can borrow foreign currency via swap lines—bilateral agreements with other central banks. The US Federal Reserve operates extensive swap lines with the European Central Bank, Bank of Japan, and others.

A swap line works like this: Central Bank A lends dollars to Central Bank B in exchange for an equivalent amount of B’s currency, with an agreement to reverse the trade at a future date. Central Bank B can then sell these dollars to defend its peg without depleting its own reserves. At maturity, the currencies are swapped back.

Swap lines provide temporary relief but do not solve underlying problems. If a country is insolvent (its debt is unsustainable) or its current account is structurally unbalanced, borrowed reserves merely delay the eventual currency crisis.

Forward Interventions and Options

Some central banks defend pegs using forward contracts instead of spot purchases. They promise to sell foreign currency at a future date, signaling commitment to the peg without immediately deploying reserves. The threat itself can calm markets if traders believe the central bank has the firepower to follow through.

Central banks may also sell call options on foreign currency (or equivalently, buy put options on domestic currency), creating synthetic barriers. If the peg holds, the options expire worthless and the central bank pockets the premium. If the peg breaks, the options cost them, but they’ve already exhausted reserves anyway.

These tools provide time to assess whether the peg is defensible or whether an orderly devaluation is preferable.

When Interventions Fail: The Limits of Defense

Insufficient reserves: If speculative selling exceeds a central bank’s reserves, the peg breaks. Thailand’s 1997 currency crisis exemplified this: Thailand’s central bank bought its own currency to defend the baht peg until reserves were nearly exhausted, then devalued sharply.

Unsustainable interest-rate differentials: If a country’s inflation is much higher than trading partners’, and the peg is fixed, the real rate becomes overvalued. The central bank must tighten severely to defend the nominal peg. Traders exploit this by shorting the currency, knowing the central bank must raise interest rates, slowing the economy. Eventually, political pressure forces a devaluation.

Structural current-account deficits: If a country chronically imports more than it exports, it must finance the gap with foreign capital inflows. If investors lose confidence, flows stop, and the peg cannot be defended. Argentina’s 2001 peg collapse followed years of unsustainable current-account deficits.

Capital flight: A sudden shock (bank crisis, political instability, war) triggers panic withdrawals of foreign capital. The central bank cannot absorb all of it. Reserves evaporate in days.

Historical Examples

The Plaza Accord (1985): G-5 central banks intervened simultaneously and massively to weaken the US dollar. Coordinated intervention, combined with clear policy intent, succeeded in shifting expectations and driving the dollar down over two years.

Thailand 1997: The Thai baht peg collapsed after the central bank exhausted reserves defending it. The currency crisis spread across Asia, demonstrating the contagion risk when pegs break under stress.

China’s yuan peg (1997–2005): China fixed the yuan at 8.27 per dollar. The central bank bought dollars continuously to prevent appreciation. When China eventually allowed a gradual revaluation in 2005, it was because holding the peg became politically and economically costly.

The Role of Credibility

The most successful interventions rely on credibility: the market’s belief that the central bank will follow through and that the peg is fundamentally defensible. The US dollar’s strength in the 1980s reflected belief in Federal Reserve commitment to monetary policy discipline. Markets did not test the peg because they expected it to hold.

Conversely, a central bank with a history of devaluing faces speculators at every crisis. Even massive interest-rate hikes fail to stabilize the currency because traders expect eventual devaluation, making the bet one-sided.

See also