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china's unsterilized FX transaction

Author: Walter Kurtz

In a recent post called Pegged renminbi will be hard to internationalize, we discussed the issue China faces as it tries to maintain its export based economy. It does so by holding the currency artificially low to make their product look cheaper to the world. To accomplish this, they must continuously purchase dollars, while selling renminbi. But where do they get the renminbi to sell?

Well in what's called an "unsterilized" FX transaction, China simply "prints" the new renminbi to sell (as opposed to a "sterilized" transaction where the central bank sells currency spot but agrees to buy it forward, thus not impacting the money supply.) The newly "minted" renminbi sold by the central bank for dollars simply gets deposited in it's banking system, increasing the money supply. This is how they keep the currency from shooting up 30%. It's a dangerous game, because all that new renminbi deposited in China's banks has to go somewhere.

With the money supply growing rapidly, China could raise interest rates to control inflation. But if they do so while the USD rates are nearly zero, it will put even more upward pressure on their currency. If you have an asset at par with the dollar that pays higher rates and can only go up in value, you'd be buying as much as you can. So as long as Western rates remain low, China has to keep their interest rates relatively low.