TO BEGIN WITH:
On 20th June 2010, China announced that it will take steps to let its currency Yuan appreciate against US dollar ending its fixed rate regime. People’s Bank of China came up with a statement the next day saying that China will not come up with a one time revaluation of Yuan exchange rate and it will be only gradual.
Markets world wide cheered this move by rising robustly the next trading day.
In simple terms, Yuan will trade in a wider band in the currency markets compared to erstwhile rigidly monitored rate by the Chinese Government.
A FEW WORDS ABOUT CHINA AND ITS EXCHANGE RATE POLICY:
China is predominantly an export oriented country. In 2008, exports accounted for 1/3rd of its GDP. It has fallen to 1/4th of GDP in 2009. Its major trade partners are Europe, US, Japan and others. In order to boost its exports, it pegged Yuan to US $ and in the process accumulated foreign exchange reserves of nearly $2.3 trillion.
China holds nearly $900 billion of US treasury securities in its $2.3 trillion reserve making it the biggest foreign creditor for US.
During 2005-08, the Yuan appreciated 21% when China moved from fixed exchange rate regime to managed float against a basket of currencies.
To protect its exports from sub prime crisis volatility, China temporarily entered once again into fixed exchange rate regime in July 2008 (peg of 6.83 Yuan/$).
Chinese bankers blamed the peg for disrupting money markets. China’s dollar purchases to maintain the peg have not only resulted in huge dollar reserve accumulations but also flooding the financial system with Yuan.
Now, after export growth has made a decent recovery ( there is a 45% YoY growth in May), China has now opened up the gates for gradual floating of Yuan exchange rate amid mounting pressure from bi lateral trade partners with G 20 Summit due this month end but with caution.
CURRENCY WAR
US Economic Experts felt Chinese Yuan is currently undervalued by almost 40%.
In March, US President Obama warned China saying- “A more market oriented exchange rate will make an essential contribution to re balancing the global economy and action will be taken on exchange rate mis alignments.”
There has been tremendous pressure on China since some time especially from Countries which predominantly trade with it (US, Japan, Europe) to revalue the Yuan as it is resulting in economic imbalances because of cheaper Chinese exports. Their domestic production has become uncompetitive as a result. US warned of imposing sanctions.
China replied on 15th June, asking not to politicize the currency issue and it is not responsible for huge US trade deficit. In fact it is working on improving bi lateral trade with US mentioning that Chinese imports from US rose by over 50% in the first quarter of 2010.
WHY THIS PRESSURE ON CHINA?
Ballooning trade deficit of US, Japan and Europe against China is the paramount reason. Trade deficit of US against China rose to as high as $227 billion in 2009 against $ 84 billion in 2000.
Once Chinese exports become expensive because of stronger Yuan, US will return to domestic production and consumption. Also, US exports too will rise since Chinese goods will be no longer cheaper. This will help US to bring down its trade deficit over a period of time.
Flight of capital from US, Japan to China can be reduced because of stronger Yuan. Because of higher profits, manufacturers started investing in China than in US or Japan or for that matter other developed countries.
World cheered Chinese move because they felt there will be restoration of economic balance i.e., economic realignment and proper distribution of capital and profits.
Also, another reason why China yielded is, domestically, China is feeling the heat of bombing real estate prices, labour union strikes for higher wages and rising inflation above Government expectations.
WHAT WILL CHINA GAIN AND LOSE AS A RESULT:
- With appreciated Yuan, the purchasing power of China automatically rises. It can import foreign goods and commodities at lower prices and increase domestic consumption. This is one reason why metal prices rose in the markets after China announced Yuan appreciation. China has huge demand for commodities and just to quote an example imports billions of yuan of iron ore every year.
- Stronger Yuan would boost domestic consumption in China reducing its dependence on exports.
- A stronger Yuan means neighbouring countries would be willing to trade in Yuan and hoard Yuan. Thus Yuan will gain prominence in World trade transactions.
- Chinese corporations having dollar debts will benefit. Example, Chinese Eastern Corp, China’s 2nd largest airliner profits would rise by nearly $40 million yearly for every 1% annual yuan rise because of devaluation of its US $ debt.
- Morgan Stanley feels a 5% rise in Yuan it expects in 2010 will result in positive 2% rise in Chinese corporate earnings.
- On the flip side, Chinese exports will be affected especially in textiles, electric and electronic components (Deutsche Bank says a 10% Yuan rise will result in 3.7% fall in textile exports and around 2% fall in components).
- Appreciation may result in capital flight from China which may eventually result in loss of jobs and lesser consumption and lower GDP. China’s falling growth may again disturb the world economic equations.
HOW WILL REST OF THE WORLD BENEFIT:
In export of textiles, leather products and handicrafts the competition between India and China is neck to neck. Indian goods will hence become more competitive in the export markets as a result of Yuan appreciation.
Capital inflows into India will increase with India’s GDP growing better and faster with higher exports.
Countries exporting goods and services to China like Australia, New Zealand, Taiwan, Malaysia, Singapore etc are bound to gain.
US feels that if Yuan was more expensive than $, American domestic production would rise and the US trade deficit will fall. But some feel, the imports may now be from other Asian countries though not China.
If prices of spare parts imported from China used in automobiles manufactured in US rise, the final product prices will go up and that will fuel inflation in US. That means weaker $ is inflationary.
Free floating exchange rate will result in automatic adjustment of balance of payments position. Free floating rate is determined by free markets. This will take a long time for Yuan for it to be totally market driven.
FINALLY:
Markets have become silent after an initial thumps up because now what is bothering the economic system is European Sovereign Debt Crisis on the bigger picture. Yuan has already strengthened 18% against Euro wiping out profits of Chinese exporters. Around 16% of Chinese exports are to EU while they are around 13% to US.
China cannot lose its export market share and hence it will allow Yuan appreciation only gradually. In the mean time, we also need to watch the asset bubble brewing in China not leaving behind social unrest demanding wage hikes. Honda yielded increasing wages more than twice while Toyota is planning to move out is some recent news.
The final word is, Chinese Yuan Appreciation is good for India. And that is what matters to us, isn’t it?
CA. SIVAPRIYA V L TENNETI
For further suggestions, corrections and queries, feel free to reach me at sivapriya.associates@yahoo.co.in
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