Yuan revaluation How much is it really worth for US?

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The US seems to be barking up the wrong tree when it insists that China's revaluation can be a cure for its own problems. Ultimately, its solution lies in its own hands. It has to increase its savings, reduce its budget deficit and set its house in order. China may be playing along with the US' demands, fully aware that no one can blame it if the latter finds itself in a mess of its own creation, says S. Venkitaramanan.

S. Venkitaramanan

CHINA'S decision on July 21 to revalue its currency, the yuan, by 2.1 per cent represents the culmination of a long argument between China and the US. The US had been pressuring China to revalue its currency, which had been pegged at 8.28 yuan to a dollar. The present revaluation is small just 2.1 per cent but it represents a "big" step, in the sense that China has shed its resistance to revaluation.

China had, for many years, been reluctant to do what the Americans wanted, citing the problems its manufacturing industries would face since its exports would be rendered less competitive. The US Treasury was adamant that the cheap yuan was responsible, at least partly, for the rising imbalance in the US balance of payments, its increasing current account gap. The Europeans also joined the group pressing for China to allow its currency to appreciate. The Group of Eight developed countries (G-8) recommended that China not only revalue its currency but also shift to a floating rate regime.

China has finally responded to the requests, which at times had been combined with threats to impose sanctions and tariffs on Chinese exports to the US. China has made a virtue of necessity and bowed to international opinion by revaluing, albeit just a little bit, 2.1 per cent. It has also signalled a movement to a new system of currency rate management relating the yuan to a basket of currencies against which the Chinese will announce an exchange rate each day. The peg against the dollar has definitely been given up, although clean floating, meaning that the exchange rate will be decided by the market, is still far away. China has also indicated that the currency will appreciat gradually.

There are a number of interesting aspects to this seemingly technical policy correction on the part of China. One is that the decision represents an attempt to set the stage for Chinese Premier, Wen Jiabao's ensuing visit to the US in September 2005. The fact that China is extremely pragmatic in its policy responses is clear from the timing of its decision.

It is true that the pending amendment by Senator Schimmer was intended to impose tariffs if China does not revalue by 20 per cent before November. But China is obviously bargaining for some more concessions from the US' protectionists. Its "small" response at the beginning is indicative of its willingness and earnestness to negotiate and, if need be, drag on the dialogue. Not for the Chinese Communists any squeamishness about yielding to US' pressures, albeit it is on a sensitive topic such as the exchange rate and how it is managed. Imagine the reactions of India's politicians if the Government were to yield to such a sensitive issue and on Uncle Sam's suasion!

What are the implications of China's revaluation for the rest of the world? Malaysia has already followed suit by depegging its currency. Hong Kong, however, sticks to its current policy. China's yuan revaluation itself is too small to make any significant change in the global demand for Chinese exports or for imports into China. The fact that Asian neighbours have moved in tandem with China is noteworthy. They obviously do not want to derive any advantage from China's revaluation. If they wanted to, they could as well have kept their own pegs unchanged.

India's reaction is still (at the time of writing) not known. One must, however, note that India is already practising a managed float and, therefore, not much change is called for, except for the fact that China's exports to India will become dearer, albeit by a small amount.

There was speculation following the July 21 announcement on revaluation whether China will dilute its policy of purchasing US Treasuries. Fortunately for the US, this has not so far happened. But one cannot rule out the possibility that China may well desist from continuing to support the US Treasury issues.

If it diverts a part of its funds to other securities, we may see a rise in interest rates in the US, which will have adverse consequences on the housing market as well as the overall rate of investment. China may not do this just yet because it depends vitally on the US as an export market. Paradoxically, its economic salvation lies in the US chugging along at a robust rate of growth. So, much as the US's senators may dislike China's interventionist policies, it is precisely these policies that are supplying China with the dollar hoards that help to support the US bond markets and keep US interest rates benign and, incidentally, supply the US consumer with cheap goods.

One other intriguing aspect of the Chinese decision is that relating to a gradual rise in the yuan. Continuing appreciation of the yuan is an invitation to further speculative flows. Once the speculator knows that there is money to be made if he brings in money today and repatriates it a few days later, the volatility of exchange rate will increase. China may need to use its tools of capital controls on both inflows and outflows if it means to carry out its policy of gradually raising the rate of the yuan.

A rising yuan spells a greater appetite on the part of Chinese corporate for acquisitions abroad. Already we have seen evidence of this acquisitive tendency in China Inc's forays into new acquisitions such as IBM, Maytag and its abortive (?) bid for Unocal.

But the US, by insisting that China revalue its currency, is only triggering further the incentive for China's aggressive acquisitions. No doubt, this will invite further protests from US "patriots" against Chinese `invasion'. But that is all in the capitalist game that the Chinese Communists have learnt to play with great finesse.

It is reported in the international press that China is adopting the formula of a basket of currencies based on the successful experience of Singapore. True, Singapore has been a successful practitioner of managed floating, with rates officially determined against a basket of currencies.

I must be pardoned for mentioning that India, too, had a successful experience with determining the exchange rate of the rupee based on a basket of currencies, appropriate weights being assigned to each currency. The exchange rate of the rupee was determined from day to day on the basis of a currency basket for nearly a decade or more.

As a result of this policy, it was possible to have a gentle depreciation of the rupee in the 1980s using this model. The weights of the different currencies were, of course, kept confidential, although a skilled expert could extract the weights from a careful study of the behaviour of officially announced exchange rates and the movement of individual currencies on the forex market.

It is a fact that the robust rate of economic growth during the 1980s had a great deal to do with successful management of the exchange rate regime. China is embarking on a path which India had also adopted before it switched over to a managed float with market-determined rates which is now in vogue and highly appreciated by international financial gurus.

The Chinese have been rightly cautious about taking decisions on revaluation and subsequent changes of exchange policy. It is worth reminding ourselves that China's exchange rate changes cannot by themselves address the massive problems that confront America or Europe.

While China's revaluation, which will make its exports costlier, will affect demand for its manufacturing industry adversely, it is not at all certain that the US will gain proportionately. Indeed, an ADB report is stated to have concluded that even a 20 per cent revaluation of the yuan would contribute to less than 1 per cent of decrease in the US's current account deficit.

The US seems to be barking up the wrong tree when it insists on China's revaluation as a cure for its own problems. Ultimately, its solution lies in its own hands. It has to increase its savings, reduce its budget deficit and set its house in order. Obviously, the US has decided to let others change policies in their countries while it continues with its spendthrift ways. Though China has yielded for the moment, it is not clear whether the Chinese revaluation will work the miracle that the US Treasury is hoping it will.

Revaluation of China's yuan is just one step of the many that the US and China will have both to take to address their imbalances. To depend on China's yuan revaluation alone to solve the problems is asking for too much. Yuan revaluation alone cannot bring about the revolution that the US policy-makers seek from it.

The Chinese leaders must be aware of the US dilemma. That is why they are apparently playing the game almost in the way the US wants it. No one can then blame China if the US finds itself in a mess of its own creation.

(This article was published in the Business Line print edition dated August 1, 2005)
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