Basically, the machine cheats, and then decides how much to let a player win.
That is to say, it’s got effectively instantaneous reactions while the best humans will have reaction times around 150ms. It doesn’t have to deal with the technical limitations of charge moves. It can time things flawlessly.
Now, while it’s possible to build A.I.s that will accurately simulate high level human play, doing so takes a lot of effort, and can be unreliable. As a consequence, the computer players don’t really play like humans.
Now, turning up the difficulty can have a variety of effects depending on the game. That includes things like increasing the damage that the computer players deal, decreasing the damage that they take, or shifting the rates of attacking, actively defending, passively defending, and walking into attacks.
There are a slew of options for the way that AI behaves that can modify difficulty, but AFAIK none of the fighting game AI is really that good. (Although I don’t have any experience, there are apparently some versions of VF which have exceptionally player-like AI.)