The Hindu Business Line : Global imbalances and China's yuan policy

Many critics question the assumptions of the Bush Administration's yuan policy, even calling the cure — of getting the currency to float — worse than the disease. China is quite unfazed, sticking to its policies. This has lessons for India, says S. VENKITARAMANAN, stressing that the RBI should keep the rupee a strong pillar of export competitiveness by weakening, rather than overvaluing, it.

We have witnessed, in recent weeks, the impact that global events have on our markets and economy. The US Federal Reserve Chairman, Dr Ben Bernanke, raises his policy rate by as much as 25 basis points and the global market, including India's, takes a hit. So, also, do oil price hikes have serious policy repercussions.

Not for nothing did the Prime Minister, Dr Manmohan Singh, devote his address at the recent ADB meet in Hyderabad to possible measures to correct what is one of the pressing global issues — the imbalances in various economies. Particularly important is the imbalance in US' current account — it imports far more goods and services than it exports. The current account gap is as high as 6-7 per cent of its GDP, a danger mark.

What is supporting the US economy are the flows of foreign capital, especially from China, Japan and the rest of Asia, as well as the oil exporting countries. These nations have no place to invest their surpluses except in countries such as the US. But the danger is that this particular remedy can last only so long as the investing nations have confidence that the dollar will be stable.

The deficit itself is a cause for the dollar to fall. Hence, a vicious circle can come about, leading to what the economists call a "hard landing" for the US and the rest of the world. One thing is certain. When the markets crash the investor countries will see a good part of their resources vanish in a decline of the greenback.

The US is continuing to apply pressure in varying degrees on China to make its currency management more flexible — that is, to force China's currency to float and, by definition, revalue it so that China's goods become dearer in the US, American goods cheaper in China and China's exports decline, leading to a fall in its current account surplus. This is the American wish-list so far as China is concerned.

Waiting game

China has played a waiting game for years now. It recently made its exchange rate policy more flexible, but only up to a limit. The US and the G(7) would also like China to relax the capital account transactions further so that "China's interventions to keep its exchange rate low are not that essential. The argument is that China can manage its currency better if there were fewer restrictions on Chinese citizens moving their savings out of China. Ultimately, China's surplus depends on its manufacturing, efficiency and productivity, which make it competitive.

Exchange rate policy is only part of the story. Chinese authorities have been resisting US pressures to change their exchange management policies while promising to do some of what the US asks of them.

At the same time, Mr Zhou Xiaochuan, Chairman of the People's Bank of China, China's central bank, has gone on record stating that the US is as much a beneficiary of China's surplus as China is. It is this surplus that props up the US bond market and helps the Fed keep a low interest rate policy. Therefrom flow the benefits of a housing boom and a rising consumption trend. Not to mention the low prices of many goods imported from China and the rest of Asia. But all this does not silence the critics of the Bush Administration's policies towards China.

The anti-China hawks want sanctions, including tariffs on Chinese exports into the US if China does not change its exchange rate policies. Fortunately, for the present, the US treasury has fought shy of declaring China a "manipulator", which would bring the sanctions on China.

Questions on US policy

There is a subtle change taking place in the US' attitude to the yuan question. It is no longer the Texan cowboy tactics of "Behave or face the lasso". The Chinese have managed to create enough self-doubt, at least among some Americans, that they have now started questioning the assumptions that underlie the Bush Administration's yuan policy.

Redoubtable academics, including Prof Ronald McKinnon of Stanford and Prof Joseph Stiglitz of Columbia, have recently come out with publications attacking the US "remedy" of a strong yuan as a cure worse than the disease. The Wall Street Journal of May 10, 2006 reports that McKinnon in his book Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue has argued that China should resist the US Administration's hectoring and refuse to abandon its policy of keeping the value of its currency, the yuan, nearly locked to the US dollar. Allowing the yuan to rise, he warns the Chinese, would send China into the kind of deflationary slump that hit Japan during the 1990s. His advice is "Don't let what happened to Japan happen to you by letting go of the exchange rate". McKinnon is not alone in advising China to resist the US' advice and strong-arm tactics. The group of China's academic friends includes two Nobel Prize winners, who also advise China to resist US demands. There is very significant concern among a lot of economists about the pressure on China to "revalue the renminbi at gunpoint".

Stiglitz' advice

Prof Stiglitz, the Nobel Prize winner, interacted directly with Chinese Premier, Mr Wen Jiabao, during meetings in China last year. He warned that China would be unwise to risk the stability of the currency. He also warned against China's liberalising forex transactions, contrary to advice given to China by the US. It might end up with Chinese resources going abroad and the yuan weakening, not what the US Administration desires!

China has always had good friends in US academia and literary circles. Edgar Snow wrote Red Star over China, a seminal work of the late 1930s. It brought the Chinese revolution to the US public.

Its depiction of the heroic exploits of China's communists in their fight against their exploiters won them sympathisers in the US as well as the rest of the world. McKinnon, Stiglitz, et al, are the Edgar Snows of the current decade, albeit academically more distinguished and experts on the arcane subject of exchange rate.

Keep rupee strong

Whatever the outcome of these fascinating details, it holds a lesson for India. China has shown that there are ways to stand up to the bully in Washington, especially when it is its forex reserves that prop up the bully's finances. To have a yuan at a competitively attractive level is good for China's economy, its exports and incidentally helps the US itself.

China has shown that it has ways of sticking to its policies and that it knows how to cultivate friends in the enemy camp. India can very well learn a lesson or two from China's remarkable success in making friends among the US establishment — academics as well as political men using their voices to aid its stance, however lonely it may appear at times.

Above all, the RBI needs to learn the lesson that a weak rupee can be a strength for India's export competitiveness. There is no point allowing it to appreciate, in the interest of exchange rate flexibility.

The RBI should explore all tools to keep the rupee a strong pillar of export competitiveness by weakening, rather than overvaluing, it. That is one enduring lesson of China's yuan episode for India.