A falling yuan is no good news for India

The 25-basis point rate hike by the US Fed on December 16 was more or less a given, what with the upward revision of its Q3 GDP growth rate to 2.2 per cent from the earlier estimate of 1.5 per cent, and a decent non-farm payroll data. This is likely to be followed up by another 75 basis points in 2016.

Besides, more hikes are expected in the future. If that happens, it will see the US dollar (USD) further strengthening against currencies of most emerging economies, especially the yuan. At the moment, yuan has a de facto peg with USD. If China continues to peg the yuan to USD, the cost of maintaining the peg will be huge.

Chinese exports decline by 3.7 per cent in November, its fifth consecutive decline. Producer price index (PPI) went down 5.9 per cent (y-o-y). Faced with excess capacities and sluggish demand, Chinese companies slashed prices for the 45th month in a row, and need cheaper yuan to help.

After its inclusion in IMF currency basket, market expects People’s Bank of China (PBoC) to let yuan float; the currency is estimated to be overvalued by at least 15 per cent in trade-weighted terms. Hence, in all likelihood, Chinese policy-makers will tolerate yuan going down further.

In November, China witnessed capital outflows of $87 billion. Its accumulated forex reserves are now down to $3.44 trillion. Analysts predict that total capital outflows from China can hit $1 trillion by year-end. All these developments indicate that trouble for Chinese currency is far from over.

Many people would like to think that yuan’s inclusion in IMF basket of reserve currency will increase its demand and check its slide. However, most traded goods and services are priced in USD, and not Special Drawing Rights (SDRs). Thus, inclusion of Chinese yuan will not make much difference to the demand for Chinese currency, at least, in the short term. Hence, the down side risk to yuan remains, and it may go down further to 7 yuans a dollar. If that happens, it will seriously complicate things for Indian businesses and policy-makers.

Given the strong trade linkage of China with other major economies — Asean, Australia, Brazil, Russia, South Korea and South Africa, in particular — weakening yuan will put pressure on their currencies to either depreciate or face lose market share.

Thus India will have to face — increased imports and increased competition from these countries in third country export markets more so when Indian rupee remains relative overvalued. Rupee has depreciated a modest 6 per cent so far this year, and that follows a strong performance in 2014 that saw rupee losing less than 2 per cent against USD.

To be specific, a weakened yuan means that India's exports of cotton yarn, copper, mineral fuels and organic chemicals, plastics and mechanical appliances to China will become expensive if rupee doesn’t decline to match yuan’s decline against USD.

India and China compete in almost all major export markets including the EU and the US for selling apparels, steel, gems and jewellery and organic chemicals. Hence, any slide in yuan against dollar will worsen India's export competitiveness vis-à-vis China. As a result, India's merchandise exports, which have been declining for the past 11 months, may have to take further beating. 

India will see not only pressure on its exports, but also increased imports of flat rolled products of aluminium and steel, power equipment, synthetic fabrics and apparels, chemicals, fertilisers and radial tyres coming from China. That in turn would mean a further squeeze on the domestic sales and operating margins of several Indian companies.

Steel and tyre manufacturers will feel maximum pinch as Chinese prices are substantially lower than those of India. India's import of finished steel went up by 71 per cent to 9.3 million tonnes in FY 2014-15 with China, Japan, Korea and Russia being the top suppliers. Things are not much different in the first six months of the current fiscal.

Chinese production capacity in steel is 800 million tonnes a year. Even a 10 per cent fall in domestic demand would mean 80 million tonnes of surplus for exports. Faced with excess capacity, global steel glut and increasing imports from China, Indian steel companies have been clamouring for duty hikes for quite some time.

The government responded by increasing import duty on steel products first in June and then by another 2.5 per cent in August. However, these hikes won’t apply to India's FTA partners such as Japan and Korea, while Chinese and Russian steel exporters are being helped by weaker currencies.

India’s import of tyres from China grew by 55.6 per cent while that flat rolled aluminium products by 46.4 per cent in FY 2014-15 over previous year. Further weakening of yuan will make it worse. And add to this, China’s export tax cuts may exacerbate global oversupply of basic materials starting from steel to chemicals, and may lead to price crash.

However, not all will be lost for Indian corporate sector. Companies dependent upon Chinese imports of mobile handsets, power equipment and active pharmaceutical ingredient (API) will benefit from excess capacities and expected yuan slide.

On the other hand, if rupee does not hold ground, and slide further which does look like a possibility — given its overvalued status, declining merchandise exports and likely impact of Fed-rate-hike on capital outflows — it will benefit net exporting sectors such as pharma, IT and textiles. However, net importing sectors will be hit hard from if rupee weakens. Though, commodity importing companies will get some respite from continued low prices.

In sum, weakening yuan will have differential impact on different sectors but heightened currency volatility is going to be something that India Inc. should look forward to next year, in addition to continued sluggish demand. Indian firms having sales in rupees and debt in USD will see their rupee cost of debt servicing climbing up sharply especially when a more than half of their forex exposure as a whole remains unhedged.

That will put further pressure on rupee, leaving policy makers with a really difficult choice – either to let rupee sink (for pushing exports and safeguarding domestic market from cheaper imports), or raise interest rate to defend the rupee. Sinking rupee will increase the rupee cost of import bill and corporate debt servicing. Interest rate hikes will stifle India’s growth momentum. That remains India’s yuan dilemma.

Singh is a a corporate economic advisor. Sharma is Vice-President, Biznomics Consulting. The views are personal

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