The world’s largest currency union contains about 1.7 billion people and accounts for more than a third of global economic output. It also may be headed for a breakup – and that’s a risk to which policy makers everywhere should be paying a lot more attention.
I’m talking, of course, about the U.S. and China. 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. Changes in the U.S. Federal Reserve’s interest-rate target affect the U.S. economy in part by causing the dollar to appreciate against other currencies, such as the euro and the yen. 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.
Over the past couple decades, China has been able to offset the effects of Fed policy by varying its relatively large level of public investment. It has always been clear, though, that China would no longer want to use fiscal policy in this way once its economy was sufficiently developed. The country’s currency moves over the past few months suggest that it might have reached this point. In other words, 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.
As far as I can tell, U.S. economic policymakers aren’t putting much emphasis on the potential repercussions of a break- up of the China-US currency union. This approach could be justified if the economy in question were the size of, say, Argentina’s (which ended its currency peg with the US in the early 2000s). But it’s not. U.S. and Chinese policymakers must recognize the global importance of their currency union and pursue its inevitable dissolution in a much more collective and deliberate fashion. U.S. monetary policy should be at the top of their agenda: There’s a significant risk that if the Fed keeps tightening in 2016, it could force an abrupt break-up. The resultant disorder in the world economy would not serve Americans well.
