The impact of China's shift to a basket peg regime on China's monetary policy has received a lot of focus. But much less attention has been paid to how this move might affect trading partners' monetary policy.
To see this, imagine the Fed trying to figure out the path of interest rate normalization before December 2015, when the yuan (CNY) was virtually fixed to the dollar. One of the key considerations would have been by how much the trade-weighted dollar index would appreciate due to an increase in the Fed Funds Rate (FFR).
This depends on the weight in the dollar trade-weighted index of the countries whose exchange rates are fixed to the dollar. And the CNY's weight alone in the dollar basket is 24 percent, according to JPMorgan estimates, as big as that of euro (17 percent) and the yen (8 percent) combined. Because nearly quarter of the dollar basket is fixed, the overall appreciation would be limited. On the other hand, because the CNY is fixed to the dollar, China would effectively "import" the dollar appreciation against the euro and the yen whose weights are 17 percent and 13 percent respectively. Put differently, China would have to carry the burden of the dollar appreciation.
But this arithmetic changes if, instead of the dollar, the CNY is fixed to China's trade-weighted basket.
As before, an increase in the FFR would appreciate the dollar against the euro and the yen (and of course other floating exchange rate currencies), which, in turn, would appreciate China's basket. But under the basket-peg regime China would now react by depreciating against the dollar (15 percent weight) to offset (partially or fully) the appreciation. This depreciation of the CNY (equivalently, appreciation of the dollar) would amplify the appreciation of the dollar basket.
The reverse occurs for the ECB or the BOJ trying to depreciate their currencies via rate cuts.