Fearing
an impending recession, the US Central Bank and the Senate
have introduced a lot of fiscal and monetary stimuli of late
to revive the consumer demand. Assuming that these stimuli
work for the purpose they are intended, it will have the immediate
consequence of increasing the domestic demand, which will
result in increasing either the domestic production or current
account deficit or both. As long as the US wage rates are
maintained at the same levels, the comparative cost advantages
of the Asian economies will remain, and China will continue
to be the largest supplier to the US, maintaining the present
US current account position vis-à-vis China intact.
Simultaneously, due to increasing imports from China, dollar will be under constant pressure to depreciate against yuan. This will not be in the interests of China because China's export competitiveness vis-à-vis US will be blunted. So China will try everything possible to maintain the dollar parity of yuan.
Such a move, however, will involve the Chinese Central Bank absorbing the complete dollar supply in the Chinese domestic market by continuous market intervention. This poses the Chinese Central Bank a two-pronged problem. One, the excess supply of yuan, released into the Chinese domestic market consequent to the purchase of dollars by the Chinese Central Bank can stoke domestic inflation. Two, large quantities of dollar reserves, which the central bank acquired as a result of market intervention, need to be gainfully deployed either in the domestic market or in the international markets.
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