An important reminder from Narayana Kocherlakota:
For more than 20 years, China has kept the yuan’s value against the dollar in a very tight range. Although the exchange rate isn’t actually pegged (the Chinese currency has appreciated at a rate of about 2 percent per year against the dollar over the past ten years), financial markets have come to expect little short-term volatility, and were unpleasantly surprised when the yuan dropped 1.9 percent in one day against the dollar last August.
This connection between the yuan and the dollar has important implications for the impact of U.S. monetary policy on China……If China holds its exchange rate to the dollar stable, the Fed’s moves will also cause the yuan to appreciate against those other currencies, putting downward pressure on Chinese inflation and employment at a time when this might not be appropriate for the Chinese economy…… the time may have come for China to break away from its currency union with the U.S.
Any such breakup presents a big problem: Many businesses and financial institutions have entered into contracts that make sense only under the premise that the exchange rate is not going to vary much over time. If, say, a Chinese firm owes a lot of U.S. dollars to a lender, a sudden change in the yuan-dollar exchange rate can make the debt unbearable, precipitating a default that would harm both the borrower and the lender. These risks matter not only for the Chinese economy, but also for the state of global finance and for the U.S. economy.
…..There’s a significant risk that if the Fed keeps tightening in 2016, it could force an abrupt breakup. The resultant disorder in the world economy would not serve Americans well.
I used the analogy recently of a giant panda running loose in a lifeboat, destabilizing the global economy. Collapse of the Yuan-Dollar peg would disrupt financial markets, hurting most global economies, not just China and the US. The alternative, holding firm on the peg, would cause severe economic stress to China and its major trading partners, including Australia, but is the lesser of two evils.
Source: The Real Reason to Worry About China – Bloomberg View