From Michael Pettis via FTAlphaville:
The best-known of these adjustment processes, and the one most relevant to the RMB, is the impossible trinity, which is simply a restatement of the way money supply must automatically adjust. In an open system (free capital flows being one of the three legs of the trinity) the PBoC can choose to peg the USD value of the RMB, in which case the money supply adjusts as money is created or destroyed in order to match supply and demand in the market in which RMB and USD are exchanged. Or it can chose to determine the size of the money supply (which it attempts to measure by looking at interest rates), in which case the exchange value of the RMB will rise or fall in order, once again, to match supply and demand in the market in which RMB and USD are exchanged.
This in fact may be one of the main reasons (which I listed above as the goal of regaining monetary freedom) the PBoC changed its currency regime. For the past two years Chinese interest rates have been too low relative to the value of the currency for supply and demand in the capital markets to balance, and we know this because China has a large capital account deficit. It experienced massive net outflows on the capital account.
