Backgrounder

The Chinese “currency” is actually two currencies. The first, the yuan (which refers to a 13th century royal dynasty), is for domestic use by Chinese citizens. The yuan is non-convertible. A Chinese person can’t take 100 yuan banknotes into a bank and buy U.S. dollars, British pounds, or Japanese yen.

The second, the renminbi (abbreviation: Rmb), replaced Chinese Foreign Exchange Certificates in 1992 and could originally be owned only by foreigners for transactions inside China.

Now Chinese citizens are allowed to exchange yuan for renminbi, renminbi for dollars, and take as much as $750 outside China. Under Chinese exchange rate rules, foreigners must use renminbi inside China for all commercial and financial purposes, and they all get the same fixed exchange rate.

The renminbi is convertible into the U.S. dollar at an exchange rate of 8.28, or about $0.1200. Through the dollar rate, the renminbi is also convertible into other major currencies.

Technically, the rate is not fixed or “pegged” to the dollar; China prefers to consider it a “managed float” in a range of 0.03 percent, which is an International Monetary Fund (IMF) classification. From the beginning of 2004, the renminbi has fluctuated between 8.2775 and 8.2763, a range so narrow that it is, for all practical purposes, a “peg.”

But it’s important to keep in mindthe concept of a managed float, because China can allow the renminbi to change by some small amount against the dollar and have it perceived as an important event — evidence that China can use to claim it was using a version of a floating currency all along.

A pegged currency or a strictly managed float is always accompanied by exchange controls that stipulate when, where, and how citizens can get foreign currency and foreigners can get the domestic currency. Any limitation on convertibility has an obvious purpose — not only to prevent capital flight in the event of problems such as social upheaval or inflation, but also to guard against a flood of cash entering a country and upsetting the money supply applecart.

Money flows into a country when it offers a higher interest rate or the possibility of a currency revaluation — as in China. And China has indeed experienced an influx of foreign money, on the order of some $60 billion over the past year. China “sterilizes” the cash by issuing its own short-term debt instruments, akin to 90-day Treasury bills in the U.S., to soak up the excess liquidity so the banks can’t lend it out, increasing domestic activity further.