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
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.
The 30 house price hotspots
While we have seen house prices sliding, these sought-after locations have seen prices jump by at least 5% over the previous 12 months
By John Fitzsimons Published
Working parents will be entitled to 15 hours free childcare for two-year-olds from next year
The government has extended free childcare hours to working parents of two-year olds but it won’t be automatic so make sure you don’t miss out
By Marc Shoffman Published