But, under any exchange rate regime, small open economies in general and emerging market economies in particular are challenged by volatile international capital flows. The challenge under an adjustable peg – a regime in which the exchange rate is fixed at any point in time but can be adjusted over time – is particularly severe.
If investors believe that a currency is overvalued, they will engage in transactions – such as purchasing assets denominated in other currencies or selling short the domestic currency – that will pay off if the currency is devalued. These very transactions will make it difficult for the country to sustain its current exchange rate.