Reading a paper right now that talks about logical consequences and reasons of pegging exchange rates. The author - John Greenwood - uses the example of the PBC - China's central bank - and outlines potential impacts of such intervention. (If you are unable to see this document, try loading it as a google doc).
The paper was written in the first half of 2008; 2 years have passed since that time and China's reserves have grown to $2.2 trillion. Usually, intervention in the market by purchasing dollars ought to fuel inflation due to increased domestic currency liquidity; however, the PBC has increased reserve requirements for banks and issued sterilization bonds to mop up liquidity.
This is similar to Indian intervention; the only defense - India's intervention is subdued.
What the Chinese Govt. can do with the RMB that is sucked up from the market, is to release it in the form of a stimulus. This article speaks well of all that is potentially wrong with China. The stimulus that China supplied amounted to 14% of GDP. No wonder inflation is beginning to spike in China, so now China is worried.
It is a rather simple story... Let's grow as fast and as much as we can. Blow ups shall be dealt with later.
Coming back to the paper... Foreign exchange intervention, if used to peg currencies, end in disasters. We know this based on failed pegged currencies in the past. The author goes onto use Malaysia's example and is daring enough to say the following:
" The main differences between Japan under Bretton Woods in the 1960s, or the smaller East Asian economies in the decades from 1980 to the present, and China today concern the issue of scale and the fact that exchange rates generally are more flexible today. As with Japan, China sterilizes almost all of its intervention, but the very large size of China’s imbalances both in absolute and relative 215 terms inevitably implies greater potential damage to itself (in terms of misallocation of investment) and its trading partners, and invites closer international scrutiny of China’s progress toward external equilibrium. On the plus side, when China runs an overall balance of payments surplus, instead of allowing its intervention actions to result in monetary acceleration, business expansion, and inflation, it cuts short the process by sterilization. While this action may stabilize the Chinese economy for a while, it is no more than a temporary palliative, buying financial stability at the cost of real distortions.
The problem for China (and other East Asian economies) is that cumulative tradeoffs of this kind exercised over several years will almost certainly exacerbate the extent of the adjustment crisis when it comes—as we saw in the case of the Asian financial crisis."
Emphasis added by me.
My fear is that the foreign exchange market has grown to such proportions, adding to which - a lot of assets in developed nations are now owned by foreign countries and corporations from those countries. Movements in exchange rates shall/ will have far reaching consequences.
George Soros had written in his book - The New Paradigm for Financial Markets - about a super bubble that has perpetuated itself for a long time now. The market has seen strains in the past decade and a half.
The Asian Crisis, The Ruble devaluation, The dot com bubble, The housing bubble, The Financial Crisis...
What follows next may well be: The collapse of foreign exchange mechanisms / markets. The roller coaster ride of China. Re-birth / Beginning of the demise of America.
I hope I am wrong.
But I see no way in which the world can come out of this hole without injuring itself.