We build a monetary model to show how expected revaluations lead to the instability of a pegged exchange rate regime. This model assumes current account convertibility and some degree of capital control, and fundamentally sound domestic policies and economy, as is the case in China. The model demonstrates that market-oriented interest rates can act as an automatic stabilizer to ease revaluation pressures, but cannot resolve them completely because the nominal interest rate has a zero nominal bound. Therefore, the official parity will eventually collapse and the revaluation expectations can be self-fulfilling, in the absence of external intervention. The empirical results of Granger causality tests are consistent with the main findings of our theoretical model. There are a number of alternative policy intervention measures that can extend the life of pegged exchange rate regime.
Ma, Y., & Sun, H. (2005). RMB revaluation and speculative capital inflows: Policy options (CPPS Working Paper Series No.164). Retrieved from Lingnan University website: http://commons.ln.edu.hk/cppswp/76/