The WSJ has a good piece today (China’s Real Monetary Problem) providing better details about problems associated with the fixed value of the Chinese yuan. In particular the article explains the process of sterilization. Let me elaborate on some of the details. (see here for a textbook version of this)

In China’s case for the past 10 years or so, there has been an excess demand for yuan on the foreign exchange market that has required the Chinese central bank (CCB) to purchase dollars and sell yuan to satisfy that demand and to maintain the fixed exchange rate. If the CCB did not intervene in this way, the yuan would appreciate with respect to the dollar. By keeping the yuan at a value that is lower than what the market would choose, of course, Chinese goods remain lower in price for US purchasers. However, the foreign exchange intervention, if this is all that were done, should have another internal effect; namely the process will cause an increase in the yuan money supply internally forcing two effects. First, more yuan in circulation would lower yuan interest rates and in a world with highly free capital mobility between countries (between the US and China it is just slightly free) the lower interest rates would ultimately reduce demand for yuan by foreign investors. In the longer term, the higher yuan money supply would cause inflation and as yuan prices increase, even though the exchange rate remains fixed, Chinese goods would become more expensive to US importers and the demand for Chinese yuan would fall. In other words, internal adjustments will compensate for the lack of external adjustments.

However, the Chinese do not want inflation to rise up in their economy. They want to keep the economy on as even a keel as possible. This is the reason they sterilize. Sterilization means that for each billion US dollars purchased form foreign investors and traders to maintain the exchange rate, the CCB sells a billion dollars worth of Chinese government securities and thereby buys up the extra yuan that would have been floated on the market. In this way the internal economy is not upset by the foreign exchange intervention. The problem of course is that this also will mean that both interest rates will not fall and prices will not rise internally and therefore the excess demand for yuan will not be eliminated.

Thus the point of the article is that the problem is not the fixity of the exchange rate but the sterilization that takes place. Eliminate the sterilization and China can go ahead and keep the fixed exchange rate since internal adjustment will allow for the gradual adjustment of the trade imbalances.