How does China control the exchange rate of its currency?

BY Paul Solman  January 11, 2008 at 3:53 PM EST

This installment’s “guest vetter” is Martin Neil Baily, now with the Brookings Institution. He was chairman of President Bill Clinton’s Council of Economic Advisors and is a certified VKP (very knowledgeable person). If you wish to be even more suitably impressed, check out his bio.

Question/Comment: How does China control the exchange rate of its currency? I don’t see it traded on the currency exchanges nor do I understand why it isn’t traded. If other currencies in the world are subject to the whim of the currency market how can China “peg” its Yuan to approximately 8 per USD?

Paul Solman: The value of a currency is similar, in principle, to the value of anything. It’s supposedly determined, that is, by supply and demand. So the Chinese yuan should be going up as folks with dollars (we Americans) supply more of them for the yuan we demand, yuan we then use to buy Chinese stuff. By contrast, the Chinese demand fewer dollars since they buy so much less of our stuff. So you have more demand for yuan and less demand for dollars; a greater supply of dollars and a lower supply of yuan. That should mean that the yuan would rise in value; the dollar, fall.

It’s like what happened with the Japanese in the ’70s and ’80s. We wanted more yen to buy their stuff; they needed fewer dollars to buy ours. And sure enough, Japan became the Land of the Rising Yen. In 1971, one dollar bought 360 yen. In 1995, one dollar bought only 100 yen.

And thus, at long last, we get to your question. Though the yuan has appreciated some 7 percent against the dollar in 2007, there is much talk of its still being woefully “undervalued.” How does China do it? Why hasn’t the yuan followed the yen’s path?

Well, China does two things. First, as you may have noticed, it doesn’t allow yuan to be traded on the open market. You can’t even take much currency out of the country. (See this for details.)

Second, the Chinese government buys huge amounts of dollar-denominated assets, primarily U.S. bonds. In effect, that is buying dollars. So they provide the demand for dollars that shores up Uncle Sam’s simoleans.

As to why China is revaluing slowly, read the next exchange.

Martin Neil Baily: The Chinese currency is not “convertible,” which means it is not traded on a market but managed by the government. Today, most major currencies are determined by supply and demand in currency markets, but not all currencies are set this way, especially those of developing countries. Back in the 1950s and 60s, most currencies were determined by government policies, not by the market. That was called the Bretton Woods system, named for the famous economic meeting in New Hampshire at the end of World War II.

Even though the yuan is rising against the dollar, it has actually fallen against the Euro and other currencies. It has remained about flat in comparison to a broad currency index.