Currency peg
When a country tries to keep its currency trading at a certain exchange rate, or within a tight range against another currency, this is known as a “currency peg”.
When a country tries to keep its currency trading at a certain exchange rate, or within a tight range against another currency, this is known as a "currency peg". In most cases, currencies are pegged to the US dollar. In the case of China, pegging its currency (the yuan, or renminbi) to the dollar worked out pretty well. In 1994, China fixed the yuan to the dollar at a rate of around 8.28 (representing a significant devaluation at the time).
It remained around this level until 2005, when it moved to pegging the renminbi to a "basket of currencies" that included the euro and the yen. Within a few years, the renminbi had strengthened against the dollar somewhat, although the authorities continued to exert a tight grip.
Maintaining the peg meant that China's exports remained very cheap, driving large trade surpluses with the US (and the rest of the world), and helping to create rapid GDP growth in China. However, as with most attempts to control or suppress markets, it had significant unintended consequences.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
In order to keep the renminbi artificially weak, China effectively had to print money to sell in exchange for dollars and other currencies. That in turn caused massive growth in the domestic money supply, which meant that credit was far too readily available, which has resulted in China having far too much debt relative to GDP.
Meanwhile, as growth has slowed, and its current-account surplus (whereby a country exports more than it imports and gets more money from abroad than it sends out) shrinks, or even becomes a deficit, China's exchange rate may no longer be undervalued indeed, it may be overvalued.
This could force China to drop the peg altogether and allow the renminbi to "free float", finding its own level. That would have a hugely disruptive impact on both the global economy and financial markets.
Sign up for MoneyWeek's newsletters
Get the latest financial news, insights and expert analysis from our award-winning MoneyWeek team, to help you understand what really matters when it comes to your finances.
-
House price affordability improves, but average first-time buyer still paying five times salary
Nationwide has reported a “modest improvement” in house price affordability over the past year, with wages outstripping house price growth, but challenges remain.
By Katie Williams Published
-
How to profit from the scramble for metals and minerals
Copper and other metals will be vital in the transition to cleaner technologies and artificial intelligence. Soaring demand is pushing prices up
By Dr Matthew Partridge Published