The Irresistible Force and the Moveable Object
As the capital account surplus is reduced while the current account deficit remains high, the pressure through the balance of payments is expressed through rising local interest rates and increasing downward pressure on the local currency. In order to maintain the peg, the central bank again intervenes, this time buying local currency (when capital was flowing in, it was forced to sell its own currency) and selling the base currency. In order to do so, it has to sell its foreign exchange reserves, which are denominated in that base currency. As local currency is bought from the market so supply is reduced and the interest rates attached to that local currency forced higher. The central bank has the unpalatable choice of sterilizing this effect by injecting liquidity back into the money market and thus effectively nullifying the effect of its foreign exchange intervention or allowing interest rates to rise and hurting the economy and asset markets in turn. As interest rates rise, so asset markets fall, forcing those investors who have stayed to cut their losses — and their positions — thus putting yet more pressure and so on and so forth. A vicious cycle develops, the length of which is decided only by the ability or the willingness of the central bank to expend its foreign exchange reserves. Eventually, one of two things happen, either the central bank runs out of reserves or the economic and financial cost of maintaining the currency peg becomes too great and the central bank scraps the peg and allows the currency to “float” (i.e. free-fall).
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