The Big Risks in China's 'Tightrope' Monetary Policy

Although the Federal Reserve refrained from raising interest rates last week, it emphasized that policy makers still believe a gradual adjustment is warranted. On the surface, that's a market-friendly policy because it means a slower pace of dollar appreciation, which would benefit emerging markets and commodities.

Then there's China, where a gradual adjustment higher in U.S. rates could mean trouble ahead for that nation's economy and markets. The U.S. federal funds rate and Chinese interest rates are linked via a “trinity” of foreign-exchange rates, capital flows and monetary policy. When the fed funds rate rises, the yuan tends to depreciate versus the dollar, and that can trigger capital outflows from China. The People's Bank of China must then respond by conducting policy in a type of “corridor” system.