For quite a long time this question was disturbing me that “we always say that china has pegged Yuan against USD consistently making it to be undervalued, but how exactly the currency value is controlled?” Mentioned below is my understanding of the concept gathered from different sources.
In order to keep its currency (yuan) pegged to the dollar, China practices the fixed exchange rate system. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.
In case of China, to maintain this fixed exchange rate, the central bank of China has had to intervene in the foreign exchange market. It sells yuan inexchange for dollar denominated assets when the demand for the yuan increases and it buys yuan with dollar denominated assets when the demand for the yuan decreases. In the past the central bank has intervened very heavily in the markets to prevent the yuan from appreciating. Since the end of 2001, dollar buying has been so great that the foreign reserves held by the Chinese government have risen by $153 billion to over $360 billion.
The intentions behind recent alteration by China in the Dollor - Yuan rate are still not very clear as the value of Yuan appreciated to 6.72 a week before G20 summit but again china made it to depreciate to 6.81. It seems China has worn a mask pretending a flexible Yuan while is controlling at the backend.