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.

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.