Over the past several weeks, the US dollar's depreciation against the euro and yen has grabbed global attention.

In a normal world, a weaker US dollar would be welcome, as it would help the US come to grips with its unsustainable trade deficit.

But because China links its yuan to the US dollar at an undervalued parity, the US dollar's depreciation risks major global economic damage, complicating the recovery from the worldwide recession.

A realignment of the US dollar is long overdue. Its overvaluation began with the Mexican peso crisis of 1994, and was officially enshrined by the "strong dollar" policy adopted after the Asian financial crisis of 1997. That policy produced short-term consumption gains for America, which explains its popularity with US politicians, but it has inflicted major long-term damage on the US economy and contributed to the current crisis.

The overvalued dollar caused the US economy to hemorrhage spending on imports, on jobs lost overseas and on investment to countries with undervalued currencies. In today's era of globalisation, marked by flexible and mobile production networks, exchange rates affect more than exports and imports. They also affect the location of production and investment.

China has been a major beneficiary of America's strong-dollar policy, to which it wedded its own "weak yuan" policy. As a result, China's trade surplus with the US rose from $US83 billion in 2001 to $US258 billion in 2007, just before the recession. So far this year, China's surplus has accounted for 75 per cent of the total US non-oil-goods trade deficit. The undervalued yuan has also made China a major recipient of foreign investment, even leading the world in 2002 -- a staggering achievement for a developing country.

The scale of recent US trade deficits was always unsustainable, and the US dollar has therefore fallen against the yen, euro, Brazilian real, and Australian and Canadian dollars. But China retains its undervalued exchange rate policy, so the yuan has appreciated relatively less against the US dollar. When combined with China's rapid growth in manufacturing capacity, this pattern promises to create a new round of global imbalances.

China's policy creates adversarial currency competition with the rest of the world. By maintaining an undervalued currency, China is preventing the US from reducing its bilateral trade deficit. Furthermore, the problem is not only America's. China's currency policy gives it a competitive advantage relative to other countries, allowing it to displace their exports to the US.

Worse still, other countries whose currencies have appreciated against the yuan can expect a Chinese import invasion. China's currency policy means that US dollar depreciation, rather than improving America's trade balance and slowing its leakage of jobs and investment, may inadvertently spread these problems. In effect, China is fostering new imbalances while countries are struggling with the demand shortfall caused by the financial crisis. The US dollar is part of an exchange-rate Rubik's Cube. With China retaining its undervalued currency policy, US dollar depreciation can aggravate global deflationary forces.

Yet a mix of political factors has led to stunning refusal by policymakers to confront China.

On the US side, a lingering Cold War mentality, combined with the presumption of US economic superiority, has meant that economic issues are still deemed subservient to geo-political concerns. All countries have been shortsighted, imagining that silence will gain them commercial favours from China. But that silence merely allows China to exploit the community of nations.

The world economy has paid dearly for this complicity and silence. It will pay still more if policymakers remain passive about China's destructive currency policy.