Thursday, April 20, 2006

McKinnon’s Error

I’ve already made this point, but I’ll take today’s Wall Street Journal Op-Ed by Ronald McKinnon as an occasion to repeat it in different words. According to McKinnon, “…China's motivation for pegging its exchange has been to secure internal monetary stability…” This may indeed be the reason they adopted the peg over a decade ago, but it is clearly not the reason they are maintaining the peg today. If the peg were being used to anchor monetary policy, then monetary policy would still be focused on maintaining the peg. Instead, monetary policy is being pursued independently of the exchange peg, and the peg is being maintained by means of reserve accumulation. If the exchange rate is an anchor, then the rope attached to it is at least several miles long.

As a general rule, exchange rates can be an effective anchor to prevent excessive inflation, because a nation with limited reserves will have to tighten monetary policy in order to maintain a peg in the face of reserve losses. The problem is, it doesn’t work in the other direction. There is no limit on China’s ability to accumulate new reserves, so the peg does not prevent China’s monetary policy from being much tighter than what would be needed to maintain the peg. If China is maintaining monetary stability (and I think they are, but that is debatable), they are doing so by a means other than the exchange peg. The only function of the exchange peg today is to shift demand to the export sector.

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13 Comments:

Anonymous Anonymous said...

How can there be monetary stability anyhow. Arent they printing money like crazy to buy up dollars. And much of it is unsterilized, eh.
Also, knzn, suppose the currency is depreciating and the bank is maintaining a peg. If they run out of reserves, can they still maintain that peg? Namely, by contracting the domestic money supply instead of intervening in forex markets. But this doesnt sound right.

Thu Apr 20, 09:59:00 PM EDT  
Blogger knzn said...

I think that China sterilizes its intervention to just the extent necessary to maintain the monetary policy that they would be following anyhow. (For example, suppose they want to maintain the interest rate at a certain level, and then they intervene to support the dollar. If they were to sterilize the intervention completely, the interest rate would go up, whereas if they didn’t sterilize at all, the interest rate would go down, so they do partial sterilization to maintain their interest rate target.) I think they manage to maintain a reasonable degree of monetary stability, in the sense that the inflation rate is not expected to go too high or too low. If they didn’t intervene at all and just used monetary policy to maintain the exchange rate, then they would have to print a lot more money than they do now, and I think there would be a serious danger of monetary instability. So the dollar peg, if they actually used it as a guide for monetary policy, would today have the opposite of its original intended effect.

I’m not sure I understand the second part of your comment. If a currency is being attacked (technically you wouldn’t say “depreciating” unless the peg had already failed) and the country runs out of reserves, they would have to act extremely quickly to maintain the peg, but they could presumably do it by raising interest rates (i.e. tightening the domestic money supply) sufficiently to attract capital. (If you pay investors enough in interest, they will start to buy your currency even if they expect it to depreciate, and as a result of the investor demand, it doesn’t depreciate – at least not immediately.) One would generally hope, though, that a country would tighten its monetary policy before it runs out of reserves, and that is the mechanism that is supposed to provide stability, in the sense of preventing the country from maintaining an inflationary monetary policy.

Thu Apr 20, 10:48:00 PM EDT  
Anonymous mvpy said...

(If you pay investors enough in interest, they will start to buy your currency even if they expect it to depreciate, and as a result of the investor demand, it doesn’t depreciate – at least not immediately.)

Thank you for response, knzn. That was indeed my question. However, when you hear of pegs collapsing, like in Asia, say, then I guess you're saying they're no longer willing to cripple the economy raising int rates to get investors back.

Also, one more thing: if the central bank wants to raise the value of their currency, do they sell domestic bonds at home or sell forex reserves on forex market. I guess its mainly the latter (again, this relates to abovementioned issue).

Fri Apr 21, 02:02:00 PM EDT  
Blogger knzn said...

“if the central bank wants to raise the value of their currency, do they sell domestic bonds at home or sell forex reserves on forex market.”

I would say, in the short run, they typically do the latter, because it’s more of a day-to-day thing, but if they are well-managed, they will end up doing the former eventually, to avoid losing too much reserves. (Most of them have interest rate targets in the short run these days, anyhow, so they would just adjust the interest rate target at the next meeting.)

Regarding pegs collapsing, yes, I would say generally it means they just decide it’s not worth it. In some cases where fiscal policy is out of control, it may not be possible for the monetary authority to raise rates with the credible expectation of keeping them up. But I think those cases are rare. I would point to Ireland in – I think it was 1992: IIRC they set their interest rate in the triple-digits to avoid capital flight, and it worked. Most nations never even try that.

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