China is holding more than $1.2 trillion dollars of U.S. government debt. If the Bank were to tap those funds to stabilize the Chinese stock market it could not simultaneously maintain an exchange rate peg. If China goes that route, look out for upheaval in the foreign exchange markets.
Chinese policy makers are now learning that lesson. The Peoples Bank of China (PBC) has allowed the Renminbi to tumble by more than 3% in the last few days. The ride may not yet be over.
What’s happening and why? It's my guess that there are investors on the margin who are pulling money out of the Chinese market and moving it into the world capital markets. Those investors are betting against the valuation that the PBC is putting on domestic assets. The outflow of funds puts downward pressure on the RMB and if the PBC were to maintain its previous parity they would be obliged to sell their holdings of dollar denominated assets to support the currency.
The PBC blinked! But that's a good thing. They’ve chosen a domestic target over an exchange rate target and to make that work, the world needs to keep buying Chinese goods.
I have advocated a policy of Treasury and Central Bank intervention to stabilize domestic asset markets. What we are seeing in the Chinese case is that this policy is inconsistent with a fixed exchange rate.