currency contagion

Schweser Book 4 p.96 emerging markets finance It says that if a country maintains its currency value to a peg while ar the same time engaging in lax fiscal and monetary policies, its currency can come under speculative attack. I don’t really understand this. A country maintains its currency value artifitially by buying and selling it on the market (mostly selling it in China’s case), if it plays around with taxes and its interest rate to keep its economy in check how does this make it more vulnerable to a ‘‘speculative attack’’ and how is such an attack carried out?

Pegging the currency and then having lax standard basically allows investors to drive the currency value. When things are good it runs it up. When things turn south, due to the lax policy that let the good times happen, investors don’t have any real “barriers” and they can exit in mass, which causes a huge devaluation and sends the govt. scrambling. I think…

Say we have a country in recession and it cuts i-rates to stimulate growth, the currency should fall in value relative to other currencies but at the same time, the country is trying to artificially maintain the currency’s value. . . investors will realize that this relationship can’t be maintained forever and investors will begin trying to exploit the differences in the peg value and what they believe its real value is. I suppose they do this by shorting it. . . potentially forcing the country to break its peg and let the market decide its value.

when a country peg its currency usually to a larger economy(eg US) and there’s no restriction on capital flow, its monetary policy is at the mercy of the larger economy. say if the us increase its interest rate, capital from the smaller country will flow to US in search of better return. And a smaller country normal defence would be a depreciating currency (which would come naturally if without the peg) to wipe out any interest rate differencial. Since the currency is peg, it has to increase domestic interest rate to match the increase in larger country to avoid capital outflow. if the smaller country cannot match the interest rate increase in larger country (which normally is the case), then clearly the peg will not hold up. the currency will have to depreciate. speculators anticipating this will borrow the smaller country currency and sell them cheap knowing that they can buy the currency later at cheaper price, pay back the lender and make some profit. thats my thot, appreciate any feedback

lax fiscal policy is associated with inflation in the LT.

part of it might have to do with the fact that small currencies can’t always maintain the peg, and if they are lax with their overall governance they might have trouble fighting speculators, and the peg will not hold up

As a practical example, I think this stuff is going on right now in Russia. Just in the past few months they have spend a huge amount of their gold and foreign currency reserves trying to prop up the ruble as energy prices have collapsed.