How Can China Control the Exchange Rate for Its Currency?

BY Jason M. Breslow  July 7, 2010 at 5:42 PM EDT

Question: I’d like to understand the mechanics behind how China will allow their currency to appreciate against the dollar. How will they do this? What will they stop doing? There are numerous articles about the politics and impacts of this change but I can’t find an explanation for how China (or any country for that matter) can control the exchange rate for their currency.

Paul Solman: It’s a really good question, Mark. Basically, China controls the value of its currency, the yuan or RMB (renminbi — “people’s money”) the way any country tries to: by manipulating supply and demand.

Let’s take demand first. China has currency controls that don’t allow yuan to be freely bought on the global market. If investors could buy yuan — or yuan-denominated bonds or stocks, even — the demand for yuan would go up. That would drive up its price.

So one way the Chinese can let the value of the yuan rise is by easing up the restrictions on the selling of yuan and assets priced in yuan.

Another way is for the Chinese to stop buying so many dollars and DOLLAR-denominated assets — U.S. stocks and bonds, that is. As the demand for the dollar ebbs, IT drops in price. The yuan, all else equal, rises.

A “convertible yuan” that trades openly on the global market is the ultimate revaluation technique.

By this point in the explanation, however, you may have noted a slight problem with the cure to an undervalued yuan: It could mean — almost surely WOULD mean — a lower appetite for dollar and thus for U.S. government dollar-denominated loans: “Treasuries.” That lower appetite would suggest that we’d have to pay higher interest rates to attract lenders to cover our deficits. That would in turn worsen our national debt burden.

How do you say “There is no such thing as a free lunch” in Chinese?