China shattered eleven years of status quo on July 21st, when it announced that it will no longer peg its currency to the U.S. Dollar. Instead, the Chinese government will allow a controlled floating peg against an unknown basket of currencies. There was an immediate revaluation of 2.1%, and the central bank claimed they would allow a maximum of 0.3% daily movement in either direction.

This event, while coming far sooner than anticipated, was not wholly unexpected. The U.S. and other developed nations had stepped up pressure for a revaluation of late, with the U.S. threatening a 27.5% across-the-board tariff on Chinese exports unless China allowed a 10% yuan revaluation. Like an international game of chess, China compromised with their immediate 2.1% shift and a restricted float; the next move is on the shoulders of the United States.

Unfortunately, the economic realities of the U.S.-China relationship are a lot more complicated than fixed exchange rates. The United States and Chinese economies are very closely tied, with each one supporting the other. To finance seemingly endless U.S. government deficits, the Treasury has to sell bonds in order to raise funds from foreign sources. China, along with other Asian countries, has in effect been buying up massive amounts of American currency at extremely low interest rates. While American Treasury bonds are attractive in their own right as the most risk-free investment in the world, they also provide essential foreign reserves a central bank committed to maintaining a currency peg needs. If China stopped buying up American debt at these low rates, we could very well face a currency crisis as bond rates and inflation would increase, precipitating a fall in the greenback.

China needs the United States as much as we need them, however. Americans are consuming almost 100% of their disposable income, and much of this money is flowing into China’s pockets. If the Chinese suddenly had to raise their prices due to a yuan revaluation, demand would fall and they would suddenly face a serious problem. They lack the domestic demand in order to keep growing at the extremely high rates they are used to. Without access to an open world market willing to import their cheap goods, China’s booming economy would suffer from major contraction. Wealth is flowing into China, increasing their domestic demand more every day, but they are still heavily reliant on exports to supplement their economy. A 27.5% tariff on goods exported to America would be terrible for their economy, and it means that all of us consumers in America would suddenly face massive price hikes, stifling consumption.

If this revaluation is such a potentially bad situation, why have Congress, the President, and the Treasury been calling for it so incessantly? The argument is that China is, in essence, subsidizing its goods in the international market by keeping its currency pegged at an artificially low rate. Some economists claim that the yuan is valued as much as 40% below a potential free-floating market rate. This means that Chinese goods can out-compete other goods in the international market, benefiting China at the expense of everyone else. It also makes it far harder for international companies, including American corporations, to open up shop in China. China is a very promising market, and undoubtedly American firms are putting pressure on the government to lower this “trade barrier.”

The optimal solution isn’t to slap on punitive tariffs or force a massive revaluation. The introduction of heavy-handed measures would be a disastrous move for both economies. Demand for Chinese made goods would crash and there would be a massive deflation, while the United States could face a currency-based crisis. Very possibly, the threat of a tariff was being used as leverage against China, and was quite empty. China did a very small revaluation in turn, calling the American bluff and deciding to slowly adapt their economy instead of facing a massive 10% revaluation. This is the elaborate chess game of Sino-American relations in which empty threats and small concessions abound.

Instead, a gradual economic shift is the ideal way to deal with the situation that has arisen, and it looks like China is pursuing this method. It is clear that the current state of affairs cannot continue indefinitely, and so action must be taken. This gives American consumers the time to change their spending habits, and it gives the American government time to balance its budget. China’s growth will slow, but they will not have to suffer from the massive deflation that would occur with a sudden revaluation. Demand will shift from international economies to their own domestic economy. Washington was right to push China, and China was right to float their currency. Hopefully this chess game will continue to be played skillfully, without any rash moves from either side. In spite of all the calls for drastic change, neither economy could withstand such a shock easily.