The Hindu Business Line : A bully in the China shop

Hegemonic powers have been known to invade territories and take away treasure. But this latest variation on the exercise of hegemonic power is that the hegemon and the `conquered' — in this case China — are bound by hoops of inter-dependence.

THE international media are agog with the news that the US has served notice on China to revalue the yuan by 10 per cent, or else. The US has even pressed into service distinguished interlocutors, like Henry Kissinger, to plead with and pressure China's leadership to heed the US' request.

The Financial Times reports that others involved in the exercise of persuasion include William Rhodes, the Vice-Chairman of Citigroup, an influential banker with a track record of involvement in emerging country finances.

If China does not yield, the alternative before it is to face the wrath of the Congress and the Senate. On the anvil is an amendment moved by Senator Charles Schumer that would impose trade sanctions if China does not revalue within six months. The bullying has gone on for quite some time. The Chinese authorities have displayed tremendous patience in facing these threats and inducements without reacting. The bully cannot be denied too long.

In blunt terms, the US demand on China is to sell its goods at a higher price to others, including the US, by 10 per cent. That is what revaluation means. A hundred remninbi will cost 10 per cent more dollars to exchange, after the 10 per cent revaluation. So, goods from China will become costlier, by a Government fiat, albeit through the exchange rate mechanism.

This is a rather strange way of using market forces when the US pressures the Chinese state to change its exchange rate to make Chinese goods dearer in the rest of the world. The consequence of China's revaluation can be serious for many consumers in the US and other countries depending on cheap Chinese goods.

But the repercussions for China's own industries are bound to be even more serious. They are already operating at wafer-thin margins. The complication could be even more damaging for China's banks, which have financed its industries. More non-performing loans can cripple the financial system.

The question is whether such a revaluation will enable the US to overcome its widening trade imbalance.

There are doubts cast on this argument. Even the Fed Chief, Mr Alan Greenspan, has come out with a statement to the effect that even a notional 20 per cent revaluation of the remninbi would have little effect on US trade balance. The US Administration is already grumbling that a 5 per cent gesture by China would not be enough.

The phenomenon of a global hegemonic power insisting that its largest trading partner revalue its currency or face the serious consequences of a trade shutdown is quite unique. Hegemonic powers have been known to invade territories and take away treasure. But this latest variation on the exercise of hegemonic power — in the sense that it asks the trading partner to change the terms on which goods are sold or bought — is more in the nature of the robber-barons of old, claiming booty from their conquered territories. The difference being that the hegemon and the "conquered" — in this case China — are bound by hoops of inter-dependence.

If the US depends on China for its supply of commodities, such as electronics, equipment, and the like, so does China depend on the US for its markets. Inter-dependence makes this relationship sustainable, even if it teeters on the edge of breaking down at times.

The implications of the US' time-bound policy guidance to China are far-reaching for both China and other countries. China's revaluation will not be an unmixed evil. After all, its foreign sector is booming and in a purely market-driven environment, its exchange rate could well have risen by more than 10 per cent due to large forex inflows.

Also, China depends a good deal on imports from other Asian countries meaning there are advantages that come with revaluation. A revalued yuan will mean China will pay fewer dollars to buy the materials and components it imports from South East Asia to make up its exports.

There have been many exercises attempted in regard to the revaluation. One suggestion mooted especially by IMF is that China should move to a flexible exchange rate and perhaps do a bit of dirty float.

The two ideas are not totally consistent with each other. But there is merit in the suggestion that China adopts the Indian mode of floating without any peg.

China may have its own reasons to avoid the suggestion. Especially are its fears legitimate because a volatile exchange rate increases the possibility of both outflows and inflows, in expectation of rate changes. The Chinese are cautious about embracing the floating model, given their fears about the fragility of the financial system and the scope for large outflows.

There have been suggestions that China adopt capital account convertibility on a more extensive scale to get the exchange rate right. This is a suggestion that has found few takers, although China has relaxed controls on capital movements to a considerable extent.

The experience of East Asia prior to the 1998 crisis showed clearly that capital account convertibility together with a pegged exchange rate is a recipe for disaster. Thailand and Mexico are standing examples of how not to go about capital account convertibility. China is too experienced in these matters to make the same mistake.

In an important paper from the International Institute of Finance entitled "China's role in the revived Bretton Wood system", Morris Goldstein and Nicholas Lardy wrote in March 2005 that "China has to step out of a system which depends on under-valued exchange rate rather than seeking to embrace an enclave economy based on a significantly undervalued exchange rate and on domestic financial repression.

China needs to accelerate the pace of financial reform, particularly banking, liberalise interest rates and reduce reliance on administrative control and window guidance and move towards greater flexibility in the exchange rate over the medium term, including immediate 15-25 per cent appreciation of the remninbi relative to a currency basket.

The authors feel these policies will promote domestic financial stability, improve the allocation of China's savings to their most productive use, provide the policy instrument necessary to manage the macro-economy, enhance the employment growth in the tradable and non-tradable sectors and are most likely to continue good access on Chinese exports in world market."

A recipe for reform that could apply to other countries than China! Maybe, India should wake up in time.

The latest remninbi episode serves as an object lesson to all countries engaged in trade with the US. So long as our goods are sold cheap to the US and we buy goods from it at its mandated prices, all is considered normal. The moment we appear to sell something cheaper than the US can produce, all hell breaks loose.

This is what happened in our outsourcing efforts. "Business Process Outsourcing" became a dirty word. Thank God, the US did not think of a rupee revaluation as the remedy for the imbalance on the outsourcing front.

It is another matter that the RBI was quietly doing its bit, helping the rupee to appreciate, albeit slowly but surely. I can hear the squeals from India's software exporters, but that is music to US ears. India has to work out its responses in case China finally yields to the US' bullying. Do we need to protect ourselves against similar attacks by the US? Or are we too insignificant in the US' trading picture to count as much as China does?

In any event, there is need to prepare ourselves in case the US' trade hawks look out for the next victim, once China is done with. It is good that we are already following a flexible exchange rate policy, not a pegged rate, which is anathema to the US ideologues. It is quite obvious that the IMF gurus have also been commendatory in their reference to the RBI's exchange rate management policies.

The danger to a globalised economy from the bullying tactics of the US is grave. It means that the rules of the game are what the hegemon dictates. The market forces are allowed to operate only so long as they suit the hegemon's interests.

China's experience should prod an effort to restructure the world's financial system so that all trading partners know and play by the same rules. It cannot be that the largest debtor country of the world sets the rules of exchange rate management of its large creditor.

The IMF and the World Bank will have to think afresh and reinvigorate the Bretton Woods institutions to revive the original spirit in which they were conceived. The IMF, if restructured as a truly global central bank, will handle the surpluses of all countries. It can be a lender of last resort. There will be neither embarrassment of riches nor any discomfiture of deprivation.

It is time to revive Lord Keynes' dream of IMF as the world's central bank and something like the bancor as the world's currency. True, the journey ahead to such restructuring is long. But the difficulties in the present structure show the need to think radically so that the phenomenon of the bully in the China shop does not recur again.

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