Nouriel Roubini has an excellent, and typically sobering piece on what he sees as the denouement of what he calls Bretton Woods 2, the system we have of less than floating exchange rates (i.e., many East Asian countries + the Gulf States maintain hard pegs; China has a dirty float).
Conventional wisdom has been that at some point rising inflation would force these countries to break their pegs (the inflation is due to considerable degree to the inability to fully sterilize the purchases of dollars they must make to keep the value of their currencies in line with the greenback).
However, Roubini, who has been prescient on this topic, sees another outcome: with world growth and demand looking wobbly, these countries (which are not the most politically stable, an important fact to keep in mind) are reluctant to risk a big slowdown or huge damage to exporters by letting their currencies appreciate.
Roubini believes they will let inflation run, and even allow it to become embedded. In the long run, this will achieve similar results to a revaluation (as local goods prices rise in nominal terms, it winds up increasing the price of exports, much as currency appreciation would. However, it would happen more gradually and (implicit in Roubini’s argument) it would be hard to point fingers (while a change in the currency regime would clearly be tied to specific authorities).
While Roubini may well be correct, that many countries will follow the path of least resistance, the consequences of this development would be profound. Highly inflationary economies are terrible for financial investment (I recall that the 24 stocks traded on Mexico’s Bolsa in 1984 had P/Es of either 2 or 4), indeed, investment of any kind.
Similarly, in the stone ages of my youth, currencies that offered investments with high interest rates were shunned. The assumption was that they were fundamentally unsound and prone to devaluation. The bad image of high inflation economies carried over to moderate inflation ones, the reverse of the yield-chasing carry trade logic of today. Although one robin does not make a spring, India is now apparently having to defend its currency from a fall, the converse of what one would have expected a year ago.
Roubini’s post is very much worth your attention. Aside from a thoughtful discussion of our current situation, it makes illuminating comparisons to the breakdown of Bretton Woods 1.