Can a Currency Board or a Hard Peg be Unstable? The Case of China

A currency board (an exchange rate regime where monetary policy depends on the evolution of foreign exchange reserves) is normally stabilizing. A loss of reserves, for instance, leads to an increase in interest rates that slows down production and improves the trade balance, resulting in an increase in foreign exchange reserves. The example of China, however, shows that a currency board or an exchange rates regime very close to a currency board can lead to dynamic instability, with an endless accumulation of foreign exchange reserves. We build a theoretical dynamic model that explains the fluctuations in exchange rate, prices, credit, interest rates and production to examine several processes that could explain this dynamic instability: rigidity of interest rates, absence of international mobility of capital (due for instance to capital controls) endogeneity of the supply of goods and stickiness of prices. The lack of financial liberalisation plays a central role in explaining the absence of stabilizing properties of the currency board in China.