Macroblog

Why Did The Chinese Stop Sterilizing?

I'm feeling optimistic that the full-time return of macroblog is imminent, but before its official there's something I have been meaning to ask.  A point I used to make way back when is that, in theory, a country that pegs the value of its currency below the freely floating market value will eventually "solve" the "problem" of the exchange rate misalignment by inflating away to the value of its money. 

How does that work?  In simple terms, to constrain the price of an undervalued currency a central bank will, in effect, print its own money in order to purchase the currencies against which it is undervalued.  In other words, increase the supply of your own currency while at the same time increasing the demand for other currencies. But, all else equal, increasing your domestic money supply will ultimately lead to domestic inflation, which in turn reduces the currency's exchange value.  Enough inflation and the currency will no longer be undervalued.  Hence, problem solved.

Which is why the case of China has been somewhat puzzling. No doubt about it, the People's Bank of China has been accumulating official reserves -- that is, purchasing assets (mainly debt) denominated in foreign currencies (mainly dollars)  -- at a pretty hefty pace for some time now.  But, until very recently, there was not much to show in the way of the inflation requested (if not mandated) by theory.

Mechanically, the reason for this is sort of apparent: Up until very recently, the PoBC has been sterilizing their foreign exchange actions.  In other words, the Chinese central bank has been undoing the effects of its exchange rate interventions with offsetting domestic monetary operations that muted growth in the overall money supply.  That is, as I said, until recently:      

• October 1, 2007 in
  • Asia
  • Exchange Rates and the Dollar
• Permalink
• Comments