The Hindu Business Line : The Yin and Yang of yuan

"NIMEN HAO," the Mandarin fortune-teller welcomed Meg and Ryan as they entered his office. They settled comfortably, after having wandered through the streets of Hopei.

He said, "You are going to have a great life. Your software business will flourish. A little one is on the way."

Ryan asked, "How did you know about my business and baby? This is amazing!"

But the next minute, when the seer foretold, "Your wife is going to spend a lot less," Ryan suddenly lost all faith in the man.

On their way back from office, Meg said, "That man is right, from now I am going to spend less — thanks to the yuan."

Ryan looked puzzled.

"Why do you think China has made a big impact on the global markets?" asked Meg.

"Cheap labour, abundant raw materials, stable political system?" Ryan made a guess.

Meg added: "Also, owing to the fixed rate of the yuan, which allowed importers and exporters to decide the prices of goods, never having to worry about fluctuations of other currencies in the market. They were always negotiating the rates in US dollars, which helped American companies to import many products from China. The foreign exchange rate is determined either using the free float or the fixed rate system. How do think the US dollar is valued?"

Ryan answered, "I know that the dollar value is determined in the open market. Everyday you hear that the dollar value has either gone down or up against the euro."

"Exactly," Meg concurred. "This is 100 per cent free float. However, the yuan has been on a fixed rate of 8.28 against a dollar for almost a decade now.

"This fixed rate was good initially, but it soon created a huge trade deficit for the US. Since the Chinese currency was always fixed, many American manufacturing facilities moved to China. Americans imported more products from China but exported less. The trade deficit between the US and China ballooned from $30 billion in 1995 to more than $100 billion in 2004.

"This would have caused a huge economic crisis in both the countries. But the Chinese government wanted to improve their economic system. The only way was to allow American consumers to spend billions of dollars on Chinese products."

Ryan saw some light in the conversation, "Aha! The Chinese were smart enough not to inflate their currency all these years. The Chinese government wanted the exports to continue without causing any cracks in either the American or Chinese economic system."

"Yes," said Meg. "To counterbalance this deficit, one solution for the US government would have been to increase taxes and long-term interest. This would have not only enhanced the US government's income but also in the Americans spending less, resulting thereby in a lower deficit. Also, the Chinese would have exported less.

"The Chinese government simply supplied money to counterbalance the deficit. It spent billions of dollars in buying US bonds and treasuries to support the trade deficit, and not cripple the economic behaviour of both the US and China."

Ryan thumped the table. "China wanted to increase its manufacturing growth and knew that US was a big spender. So it supplied its own money to the Americans to buy the products from China. But what bothers me is if this can go on forever — China having billions of dollars of US bonds."

Meg observed. "In fact, once Chinese textile manufacturing picked up, both India and Italy are lagging far behind in their textile supplies to the US.

"In spite of heavy exports, the Chinese currency was always at 8.28 yuan against the dollar. The whole world knew that the Chinese currency was undervalued, but couldn't do much; the rate was fixed by the government.

"A country's currency strengthens when it exports more than it imports. If a currency is getting stronger, then exports from the country would slow down and imports would start increasing. At Rs 50 a dollar, it is cheaper to buy Indian goods/services and imports from the US will be lower. But at Rs 42 a dollar, exports from India will be more expensive but imports to India become more attractive as more dollars can be bought for the same rupee value.

"This is what the rest of the world wanted. In fact, there was heavy pressure from the US to float the yuan in the market, and let the market decide its fair value."

Ryan interrupted, "If the Chinese government allows the currency to float fully in one go, wouldn't this make a big impact?"

"True," Meg answered. "The Chinese government, as a first step, has revalued the yuan by 2 per cent, strengthening the currency to 8.1 to a dollar, and allowed it to vary by 0.3 per cent. This would not only appease the US government but would also allow the Chinese economy to grow without hurting."

Ryan smiled. "So, if a bike from China sold in Wal-Mart was available at 830 yuan, I would be paying $100 for it. By revaluing the currency to 8.1 yuan, the same bike at 830 yuan would cost $102.46."

"That's fast math," Meg applauded. "Even though this has a minimal impact for a single consumer, imagine the effect when billions of dollars are involved.

"If American companies have to pay more for the goods from China, then they have to pass on the cost to consumers, who would have to pay more than before for the same goods."

"Soon inflation would increase and consumers would begin to spend less. Imports from the US to China will bring in more dollars for the former. So, American goods will now become more attractive to China, and Chinese goods will become more expensive to the Americans.

"This is what Alan Greenspan and other economists are hoping will happen. Even though a sudden rise would cripple the economy, a slow rise in the rate of yuan would strengthen both the economies and bring down the trade deficit," Meg took a breather.

"Now I understand the reason for the re-valuation and your sudden but welcome decision to spend less!" said Ryan"

Meg summed up, "Now that the Chinese government has revalued the yuan there are expectations of a further 5-10 per cent revaluation. Not sure when it will happen, though.

"BTW, Can you guess why GM and Volkswagen are ecstatic about the Chinese yuan being revalued?"

Before Ryan could reply, she said, "Something to think about, huh?"

Racy@thehindu.co.in

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