I had always casually wondered how this little maneuver works. How exactly does China keep its currency pegged to the U.S. Dollar, or more recently a “basket” of foreign currencies, and how does it let it rise? In the New York Times article noting the most recent minor shift in currency policy, I got my answer. The Chinese government borrows by issuing Yuan-denominated bonds from its own central bank in order to buy up U.S. Treasury securities to fill its huge foreign exchange reserves—$1.2 trillion worth. Here’s the neat part:
The central bank earns a higher interest rate on American Treasury securities than it pays on yuan-denominated bonds at home. The authorities use this profit from the difference in interest rates to cover losses on the foreign exchange reserves, which are worth less and less in yuan as the yuan appreciates.
So higher interest rates in the United States allow China to let its own currency appreciate.