As the global economy recovers, the tension arising China's desire to restrain inflation while keeping the yuan undervalued through a de facto dollar peg is heightened. In an article about a small increase in interest rates, the Times' Keith Bradsher provides a nice explanation of the "sterilization" mechanism that China uses to reconcile the contradictory policy objectives:
Because China does not have a well-developed bond trading market, the yields on the weekly sales of central bank bills are widely watched as a barometer of the central bank’s intentions.
The central bank sells its bills mainly to banks, which pay in renminbi that the central bank then effectively takes out of circulation, slowing growth in the country’s money supply.
Weekly sales of central bank bills are part of a process that economists describe as “sterilization” of China’s extensive intervention in currency markets.
As U.S. dollars and other foreign currencies pour into China from its trade surplus and foreign investment, the central bank prints vast sums of renminbi and issues them to buy those dollars and other currencies.
To prevent all those extra renminbi from feeding inflation, the central bank then claws back the renminbi from the market through a series of measures that include the sale of central bank bills. China also requires commercial banks to keep large reserves on deposit at the central bank, partly to keep the banks from lending too recklessly but also so that the central bank can use that money to finance further purchases of dollars and other foreign exchange.
The goal of sterilization is to keep inflation under control in China while keeping the renminbi weak. That helps make China’s exports competitive overseas and preserves jobs in China, while contributing to unemployment in countries producing rival goods.
The U.S. dollars and other currencies go into China’s foreign exchange reserves, which stood at $2.27 trillion at the end of September; monthly figures through the end of December are due for release next week. China has the biggest foreign exchange reserves of any country, by far.
For this policy to be effective, China has to limit financial inflows, preventing speculators from putting pressure on the yuan by betting on an appreciation. Higher yuan interest rates increase the incentive to move funds to China. Surely, this cannot go on forever....