Within an well-functioning economy, having financial assets denominated in the national currency gives an ability to command resources that are available within the nation. Because of that, people often confuse financial assets and resources, and that confusion is what is behind people's mental model of what China's options are.
But when you are using reserve transactions to stabilize exchange rates, then that's what you are doing with them.
That is, you can drive a car to work, you can drive a car to the beach, you can't drive the same car to both places at once (assuming that you do not work at the beach, of course). If a central bank is issuing enough currency to discount its exchange rate, net purchases of foreign currency with domestic currency is required.
Or, when two countries bilaterally agree to maintain a stable exchange rate, the central bank that has to do more discounting to maintain it ends up with more reserves denominated in the other currency ... but its not "financial investment", its a side-effect.
Indeed, that is part of the story of how the ERM fell apart. Speculators realized that Germany's Central Bank, which had to do the discounting to maintain the Mark/£ rate, likely would not in fact do it if really pressed, bet that way, and their betting that way put pressure on the exchange rate. The Bank of England trying to prop up the exchange rate from their side just threatened to exhaust their reserves while at the same time providing fresh sources of finance for the speculative activity ... like trying to put out a kitchen fire by pouring kerosene on it. I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
part of the story of how the ERM fell apart. Speculators realized that Germany's Central Bank, which had to do the discounting to maintain the Mark/£ rate, likely would not in fact do it if really pressed
Isn't such a system inherently stable unless the central bank with the largest currency in the system sees it as its job to curb exchange rate fluctuations? The brainless should not be in banking -- Willem Buiter
(1) Strong restrictions on cross-border flows of financial wealth; or
(2) Action by the central bank of the currency facing upward pressure to maintain the exchange rate.
Of course, (1) would be contra to having an Economic Union in the first place, leaving (2).
In that context, it was the Bundesbank that controlled the currency facing upward pressure. If they had stood ready to buy as many £sterling as required to stabilize the rate, the speculative pressure could never have brought down the system.
But "stand ready" means as a priority over whatever the domestic impacts may be ... in a system with freedom of movement of financial wealth, domestic reserves cannot be generated to acquire foreign reserves without those domestic reserves getting out there.
The UK could also have relieved pressure by increasing financial demand for £sterling by raising their cash rate, but for domestic policy reasons were unwilling to do so. Germany could have also relieved pressure by reducing financial demand for Marks by dropping their cash rate, but were unwilling to do so, AFAIU for the same domestic policy reasons that they were unwilling to stabilize the rate directly.
And of course while the Bank of England would have been willing to prop up the £sterling with a "large enough" pool of foreign exchange, a central bank protecting an exchange rate premium sooner or later does not have a large enough pool of foreign exchange.
Hence the Euro: for those EU economies relying primarily on fix-price product sales within the EU, the exchange rate that is never subject to speculative attack is the money:bank-settlement-account exchange rate of 1:1. I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
However, the country with the larger GDP has an easier time dealing with that upwards pressure, in proportion to that GDP (or to the size of its money supply).
So Germany had an easier time defending exchange rate bands than smaller ERM economies. The brainless should not be in banking -- Willem Buiter
- Jake If you only spend 20 minutes of the rest of your life on economics, go spend them here.
I think you are assuming a constant size of the swarm of sharks. I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
