The Hindu Business Line : When will a yuan revaluation happen?

CHINA is among the big stories of the global market. When and how China will modify or revalue the pegged exchange rate of the yuan currency against the US dollar is the key issue.

Note that it is almost taken as axiomatic that a modification of the Chinese peg means an upward valuation of the currency. This is indicative of the overall favourable investor sentiments towards Asia in general. Therefore, it is not surprising to see all Asian currencies — including the Japanese yen and the Indian rupee whose export complementarity with

China is not as high as, say, Korea, Taiwan or Thailand — rising sharply on rumours and speculation about an imminent revaluation of the yuan. The Indian rupee, for instance, hit an almost six-year high of Rs 43.25 against the dollar last week.

Ramifications of yuan change

Such sharp up-moves in the exchange rates of Asian currencies, if sustained, could have significant implications for other segments of the domestic financial markets in the respective countries.

The ramifications could extend to overall macro-economic policy also — for instance, on the interest rate, external trade, or tariff policies, and even on the Budget etc.

It is, then, important to get a grip on how imminent such a major, global policy move — the yuan revaluation — is going to be.

Financial market participants have, in the recent past, been frequently buffeted by plain rumours, remarks by high-ranking Chinese officials on both sides (for and against revaluation now), articles in state-controlled media (again, arguing for and against). Everyone realises that a revaluation is bound to happen sooner or later and is straining to be the first to notice it and act on it.

Timing and magnitude

Whatever the US or multilateral institutions such as the International Monetary Fund or the Organisation for Economic Cooperation and Development may say, an analysis of the overall issue indicates that China's decision on yuan revaluation will be a function mainly (if not solely) of its domestic environment. Any revaluation of the yuan will likely create a drag on the employment-intensive export industries.

How China handles this issue will be the key to the timing and magnitude of any revaluation. The overall state of the US economy will also be an important factor in the calculus. A robust US economy with aggregate demand at perked up levels will be a more conducive environment for the Chinese to attempt any noticeable revaluation.

The export numbers and the larger picture

Consider the numbers. Close to 16 per cent of China's GDP of $1.2 trillion is accounted for by exports to the US alone. Exports to the US ``also constitute close to 35 per cent of total Chinese exports of around $500 billion".

One gets an idea of the size and breadth of the Chinese export machine here. Exports alone account for 30 per cent of GDP and the total trade (exports and imports) account for more than 50 per cent of GDP.

It is evident from these numbers that the country relies critically on maintaining and growing export demand for its products. Domestic demand cannot act as a shock-absorber to make up for any loss of export demand consequent to sharp exchange rate moves.

Even if the domestic monetary policy is sufficiently fine-tuned to counter any drag in the economy brought on by exchange rate adjustments, the likely outcome of such a monetary policy change would be ambiguous. For one, there will be an inevitable time lag for any accommodative monetary policy move to seep through into the domestic economy. The time lag would also be a function of how efficient the monetary policy transmission mechanism is. And here, one should note that the Chinese banking market is only opening up now to competition and there is a long way still for classical monetary policy actions to act the way they are intended to.

If anything, this concentration of GDP and relevant economic parameters such as the level of employment in international trade — more specifically export trade — could be the soft under-belly which the Chinese have to handle cautiously. They have to cushion or mitigate the adverse impact of any exchange rate move on the employment picture.

Given the above configuration of economic conditions, one is not at all sure about the imminence (meaning the next week or month) of a yuan revaluation. But there is enough in the current environment to keep the rumour mills working overtime and justifiably so.

Impact on rupee and markets

The impact on the Indian markets of any Chinese move though could be striking if last week's move in the rupee is any indication. Leaving aside the issue of a low but growing level of complementarity between Chinese and Indian exports, there is an undercurrent of investor bullishness about all Asian asset classes — be it currencies or stocks. A Chinese revaluation would only confirm that undercurrent. The Indian rupee could easily move up a per cent or two on the back of a yuan re-set.

Such a move could throw up many interesting possibilities in other segments of the domestic financial market. For one, it could take quite some strain off the Reserve Bank of India in its forex market operations.

The scale of intervention required to prevent, or even slow, a rupee up-move following a Chinese revaluation could also be quite high. The liquidity and inflation-expectations effects of such dollar-supportive intervention could also be unpredictable. Therefore, it is quite possible that we will see a solid appreciation in the rupee, of a per cent or two, following a Chinese move up. Simultaneously, we could be seeing more relaxation of controls on the BoP capital account and, also importantly, domestic monetary policy could gain a good measure of flexibility in such a scenario.

The Indian banking system is certainly better placed to transmit accommodative monetary policy on to the broader economy. Indeed, it is quite possible that Indian monetary policy will turn accommodative from the current cautious stance and Indian interest rates trend lower following a Chinese revaluation.

(The author is Associate Vice President — Treasury — ING Vysya Bank Ltd. These are purely personal views and do not represent those of his employer.)

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