This is an unsustainable paradigm but interesting while it lasts.
Actual inflation works to weaken a currency (it buys less in general, by definition). Under those circumstances, acting to keep your currency strong first causes the trade flows reverse, and then to continue to keep it strong market forces tend to eat up your fx reserves. All of them. And then some. To the point where the local currency can no longer be supported short of additional fiscal tightening sufficient to reduce ‘real’ wages vs your trading partners.

Yuan Gains by Most in Three Weeks as Zhou Says Inflation High

By Brian Parkin

May 20 (Bloomberg) &#8212 China’s yuan rose by the most in three weeks after People’s Bank of China Governor Zhou Xiaochuan said inflation remains “high,” fueling speculation further gains will be tolerated.

China needs to strike a balance between economic growth and consumer prices, Zhou said at the Lujiazui Forum in Shanghai today. Asia’s largest economy is “cautiously” promoting cross- border use of the yuan in financial transactions in addition to trade and investment, he said, adding that the onvertibility of the yuan should be a gradual, orderly, mid-to-long-term process.

“The official commentary has been leaning towards expounding the benefits of yuan flexibility,” said Emmanuel Ng, a currency strategist at Oversea-Chinese Banking Corp. in Singapore. “It has been mentioned as a bit of an inflation tool.”

The yuan rose 0.17 percent to 6.4926 per dollar as of 4:30 p.m. in Shanghai, resulting in a weekly gain of 0.08 percent, according to the China Foreign Exchange Trade System. The currency isn’t allowed to move more than 0.5 percent either side of the central bank’s daily fixing, which was raised 0.10 percent today to 6.4983. In Hong Kong’s offshore market, the yuan strengthened 0.08 percent to 6.4915.

Twelve-month non-deliverable forwards gained 0.05 percent to 6.3645 per dollar from yesterday, a 2 percent premium to the onshore spot rate, according to data compiled by Bloomberg. The contracts were little changed from last week.

A stronger currency helps tame inflation by reducing the cost of imports. Consumer prices rose 5.3 percent in April from a year earlier following a 5.4 percent increase in March that was the biggest since July 2008. The government aims to limit inflation to 4 percent this year.