The Hindu Business Line : Yuan revaluation — Implications for China, US and India

China has ended its decade-old fixed peg to the dollar by allowing a mere 2 per cent appreciation of the yuan vis-à-vis the dollar. If the revaluation stops at that, there may not be any appreciable change in the overall trade balance for the US or China. For India, however, the degree of competitive advantage will depend on whether the rupee will appreciate against the dollar and other major currencies, says Alok Ray.

INTERESTING times are ahead for India. China has ended its decade-old fixed peg to the US dollar. However, contrary to expectations of a one-shot large change of 10-15 per cent, China has allowed a mere 2 per cent appreciation of the yuan vis-à-vis the dollar.

However, no one is yet sure if the Chinese are really serious about letting their currency be more market-determined or is it just a one-time small concession to protectionist threat by US Congressmen against Chinese imports unless China revalues its currency. The Chinese central bank has indicated that it is going to link the value of the yuan to a basket of major currencies, though its composition has been kept a secret. It will allow the value of the yuan to change within a band of 0.3 per cent either way from the previous day's closing. This crawling peg may open the door for creeping revaluation, rather than a big bang change.

China had for long resisted tremendous political pressures from the West to revalue the yuan. Then, why now? First, many influential US Congressmen (both Democrats and Republicans) recently rallied to press for penal import duties on Chinese goods, unless China changed its rigid exchange rate policy, which has helped it run a massive trade surplus with the US ($175 billion in 2004).

The overall global trade surplus of China was only $31 billion in 2004, implying that it has a trade deficit with the rest of the world excepting the US. This has led many in the US to believe that China is getting an unfair advantage by not letting the yuan-dollar rate be market-determined.

Second, recently, the friction with the US has further heightened, as China, instead of investing its dollar reserves in low-interest US Treasury bills, is now trying to take over US companies such as Unocal — a trend which many American politicians are regarding as national security risk. This may have been the immediate trigger for China's reversal of exchange rate policy to pacify US public opinion.

This is particularly needed as the Chinese Premier is scheduled to visit the US in September. Third, China is still growing at a break-neck speed of 9.5 per cent in the last quarter. That means it can afford to have a lower trade surplus, and yet maintain a reasonable growth rate. Next, the possible consequences for the US, China and India. If revaluation stops at just 2 per cent vis-a-vis thedollar, there may not be any appreciable change in the overall trade balance for the US or China.

However, if by "managed floating" China means more `floating' than `managed', then the yuan should continue to appreciate vis-a-vis the dollar till the trade deficit of the US against China comes down to a more manageable level. In fact, indications are that China is shifting more and more to domestic consumption boom, rather than on investment or export surplus, to sustain its growth momentum.

What will happen to the value of the dollar against other currencies such as the euro? If China allows a substantial revaluation of the yuan vis-a-vis the dollar in the days to come, the euro may go down against the dollar from its current high. Since China maintained a fixed peg against the dollar, the latter had to fall more against other currencies such as the euro to make the necessary adjustment in its global trade balance.

Indian goods will derive a competitive advantage over that of the Chinese to the extent the yuan appreciates against the dollar and other major currencies (such as the euro and the yen). However, a 2 per cent appreciation of the yuan may not bring any significant change. Some analysts believe that China enjoys a cost advantage of 10-15 per cent over Indian textiles. That being the case, a 2 per cent tilt of balance in favour of Indian goods will not be able to swing the scale in favour of India.

Moreover, the degree of competitive advantage will depend on whether the Indian rupee will appreciate against the dollar and other major currencies. That would hinge on whether the Reserve Bank of India will continue to buy dollars from the market to prevent the rupee from appreciating.

Some think that the yuan revaluation will make life easier for the RBI as it can now afford to let the rupee appreciate to some extent, without undermining the competitive position of Indian goods.

This would ease RBI's burden in sterilising the effect of foreign exchange gains on domestic money supply by selling more government bonds. The resulting appreciation of the rupee vis-a-vis the dollar will make imported goods cheaper at home, helping the Government reduce the inflation rate (especially by lowering the rupee price of oil) and lessen the pressure to adjust the interest rate upward to keep pace with inflation. Again, a lot may depend on what other Asian competitors do. For example, the Malaysian central bank has already changed its currency from a fixed rate against the dollar to a managed float. More countries may follow.

If foreign investors believe that the yuan will appreciate significantly against the rupee in the near term, then more foreign direct investment may flow into India for two reasons. One, they will get a higher amount of domestic currency by investing a given amount of dollars in India relative to China. Two, to the extent FDI goes into export industries, exports from China (compared to from India) will be more expensive.

How about FII money flows and the impact on the Indian stock market? Most foreign investment in China takes the form of FDI. Hence, FII inflows into India may well continue so long as India remains a bull market. Moreover, to the extent the rupee is expected to appreciate, more FII money may come in right now to take advantage of an exchange gain. What about the longer run, assuming that it is the beginning of a creeping upward journey of Chinese yuan against other major currencies? At this moment, Wal-Mart sources some $18 billion worth of goods from China while its purchases from India is about $2 billion.

So, if Indian goods manage to offer a significant price advantage, major global buyers such as Wal-Mart and Gap may source more from India and less from China. In fact, big buyers such as Wal-Mart are already a little apprehensive about keeping almost all their eggs in the Chinese basket. So, they would be happy to diversify their purchases.

Basically, Indian exports will be cheaper abroad. If not limited by supply constraints, India's sales in global markets will increase. Of course, the relative advantage for Indian producers will be less if they import inputs from China, which would be more expensive in rupees. Over time, this may provide an incentive to Indian manufacturers to source materials from countries other than China.

Finally, what will happen to the US, which is maintaining its artificially high standard of living by borrowing cheap from countries such as China, which are investing their massive balance of payments surplus in US government bonds at a low interest rate? If that policy is reversed by China, the goods imported by US from China will be more expensive.

Moreover, interest rates will rise in the US as the flow of cheap funds slows. US manufacturing industries may be able to sell more of their cheaper goods, but the real-estate boom built on low interest rate will end. The big question remains: What will happen to US' stature as the No.1 economic and political superpower when China takes away its credit card?

(The author is Professor of Economics, Indian Institute of Management Calcutta, and visiting Professor of Economics, University of Rochester, US. He can be reached at alokray15@yahoo.com)

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