The anatomy of a peg: lessons from China's parallel currencies

China's current account transactions use an offshore international currency, the CNH, that co-exists as a parallel currency with the mainland domestic currency, the CNY. The CNH is freely used, but by restricting its exchange for CNY, the authorities can enforce capital controls. Sustaining these controls requires tight management of the money supply and liquidity to keep the exchange rate between the dual currencies pegged. After describing how the central bank implements this system, we find a rare instance of identified, exogenous, transitory increases in the supply of money and estimate by how much they depreciate the exchange rate. Theory and evidence show that elastically supplying money in response to demand shocks can maintain a currency peg. Liquidity policies complement these monetary interventions to deal with the pressure on the peg from financial innovation. Finally, deviations from the CNH/CNY peg act as a pressure valve to manage the exchange rate between the yuan and the US dollar.