Physicist, Startup Founder, Blogger, Dad

Sunday, May 08, 2005

FX sterilization costs

The latest Morgan Stanley economic digest has several interesting commentaries.

Andy Xie predicts no near-term yuan revaluation: "China’s ability to sterilize hot money inflow is still plentiful. China’s yield curve is below the US dollar’s yield curve – i.e. sterilization is still profitable. The inflationary pressure is still limited to cost pass-through from higher commodity prices. We forecast a 3.5% inflation rate for 2005. Neither the inflation rate nor the yield curve is a problem in terms of China sticking to the peg."

I've heard the same observation before re: Japan. Higher dollar yields mean that issuing renminbi-denominated bonds to absorb dollars (and reinvesting those dollars in US fixed income securities) is a profitable trade for the central bank. However, this ignores the huge future losses that will be incurred from a devaluation of the dollar (see Economist coverage here, and earlier discussion by Brad Setser here).

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