China uses up US$100 billion of foreign reserves in a month

Exchange rates are generally set by the foreign exchange market. The demand and supply of a currency in the market determines it's price, just like any good or service.

Some countries choose to fix their exchange rates, but they are usually small countries which need the stability of a stronger, low inflation currency.

China has never favoured freely floating exchange rates, but they don't like official fixing the value of the currency either. However China has generally sought to keep the Yuan at a level that assists Chinese competitiveness.

The chart, from Trandingeconomics.com shows how the Yuan steadily appreciated until the mid-90's. Then China intervened more strongly to maintain a fixed exchange rate and prevent Chinese exports becoming too expensive. (Note periods of earlier intervention.)

The fundamental economic indicators for China from 1995 until recently were very strong. Double digit growth led most to conclude China was the place to invest and China didn't disappoint them. Today Chinese growth is slowing and they have to cope with inflation, a novel problem for them. Some are looking elsewhere for opportunities.

So capital is now leaving China, the trade surplus is getting smaller and, as economic theory would predict, the exchange rate is falling.

China has responded by trying to maintain the exchange rate. There are three ways of 'managing' a floating exchange rate (sometimes called a dirty float).
1. Raise interest rates
2. Buy your currency of the foreign exchange market using foreign currency.
3. Talk your currency up.

China has been using option two. And they have a lot of foreign money in reserve to do this (Over US$3 trillion). Years of huge trade surpluses have allowed China to build up this substantial stock of foreign currency.

Can they really carry on spending US$100bn a month to maintain the Yuan's exchange rate? The answer is no. The article from Forbes below provides valuable details and suggests that China can only afford to spend about a third of their reserves - that means at this rate they have no more than a year before fundamental economic forces get their way with the Yuan.

The Forbes article is here

How the foreign exchange market works is part of VCE and IB. This particular story is especially useful to IB students and they should be able to explain how exchange rates are set and how intervention in the market works using demand and supply analysis. There are many articles on this topic suitable for use in an IA.