Yuan Revaluation

Date: August 2005.

Implications of Yuan revaluation – An Interesting Tale

The yuan revaluation was very much awaited all over the globe for atleast a decade. Finally on July 21^st the PBC removed the 11-year-old peg, which the Chinese currency had with the US $. Though the revaluation did not have anything great to write home about (just 2%), it is indeed a step in the right direction. From now onwards the Yuan will be linked to a basket of currencies that will be determined at the end of each days trading.

The upward revaluation of the yuan by 2.1% has created huge ripples in the forex market with a lot of analysts offering their own Gyan on the repercussions of the Chinese action. The PBC has indicated a bandwidth of 0.35 from the previous day closing.

This article is also aimed at offering such gyan but this involves gyan with a wider perspective. Let us analyse the impact of the revaluation in a three-fold manner

Chinese Impact:

As we all know China is close ended as far as information availability is concerned.

The Chinese are used to reporting over growth in GDP and other macro economic indicators. They are not known for the best of reporting practices. Still the country is considered an Asian Super power mainly due to the following reasons:

1. Reduced domestic spending and more concentration of forex money for infrastructure

2. Financing of imports through their forex reserves

3. Major part of the forex money is in the form of FDI thereby indicating stability in the economy

4. Their input costs in the manufacturing sector are minimal and therefore most companies have high operating margins, which augur well for the industry.

The US Congress has all along been demanding a change in stance by the PBC(People’s Bank of China) to revalue the yuan due to the heavy forex reserves in China and it’s trades imbalance with the US. Consistent pressure was exerted in this regard as US was a major importer of Chinese goods. The US senate was also considering the possibility of imposing duties and taxes on imports from China . In this scenario the Yuan revaluation by 2 % is a welcome measure. However China is not too happy with the revaluation. The PBC chairman has stated that a stronger yuan can lead to more capital inflows and considering the capital outflow restrictions in place in China, it can only lead to the accumulation of forex reserves. Too much accumulation without any major domestic spending can lead to weakening of interest rates. This point can be confirmed from the fact that the savings rate is 40% in China compared to a mere 2 % in USA. That is the major reason for China not revaluing Yuan as per the actual expectations. However the US market is very important for China as can be seen from the fact that exports to the US account for 37% thereby clearly indicating that US views are too important to be ignored.

Impact on US:

As already mentioned above the US has been demanding an upward revaluation of the Yuan for a long time. The basis of their demand is that

1. The Chinese have a huge trade surplus with the US amounting to nearly 180 billion $ whereas their global trade surplus amounts to 31 billion $ only which starkly indicates that the Yuan has a trade deficit with all other countries

2. There is a huge trade imbalance in Sino –US relations.

3. There has been a huge security threat in US of possible takeover of US companies by the Chinese. These fears have emancipated from the recent bid by the Chinese for the US energy major UNOCAL. The fears also stem from the recent change of guard in Chinese investment strategy. All along China used to reinvest its forex money from exports to US in low interest US treasury bonds. But of late there has been an interest in takeovers, M& A and inorganic growth.

4. Chinese imports from US also form a very meager portion. Most Chinese imports today are in the form of iron and steel which are required for the Beijing Olympics in 2008 and US is not a major supplier of both these items.

But however even though the US has been demanding a Yuan revaluation, they are still walking a tight rope. The 2% upward movement of the Yuan should satisfy them for the time being. Even Alan Greenspan must be conscious of the fact that the low interest rates in the US are a result of the Chinese action to invest in US govt treasury bonds. This huge Borrowing power of the US has only resulted in the high standard of living of its citizens and China has been its unlimited credit card. The author does not think that the US will rub China on the wrong side for the time being. The Whole real estate boom in the US has been built upon the fact that interest rates are low. Once China decides to withdraw its credit to the US, the paucity of funds can have disastrous effects to the position of the No.1 economic superpower.

Indian impact: Now coming to our own country – The upward movement in the Yuan will also see the rupee rising against the dollar in the short term. If there is a further upward movement in the Yuan (which may be possible) then there will be a competitive advantage for Indian goods, which will prove to be cheaper in dollar terms. But if we take the textile sector as an example the Chinese still have a 10- 15% cost advantage compared to India. Therefore a 2% appreciation in Yuan will not tilt the scales in favour of India. The degree of competitive advantage shall also depend upon the RBI action – whether the RBI will also allow the rupee to appreciate in proportion to yuan appreciation against the $. Right now RBI buys $ from the forex market to prevent rupee appreciation. The resulting appreciation in Indian rupee vis a vis the $ can lead to cheap imports and reduction in inflation and domestic oil prices.

The Yuan appreciation over the rupee can also have a positive impact for India :

Ø There will be more FII $ inflows into India when compared to China as the realization in rupee will be higher than the Yuan realizations.

Ø As more and more FDI inflows into the Indian export industries takes place the exports from India will be cheaper than exports from China giving us a significant price and volume advantage over the Chinese.

Ø Also the possibility of Rupee appreciation will bring in FII funds with the arbitrage motive of making gains on appreciation

Ø Entities like Wal-Mart and McDonalds have an input sourcing policy (from china and India), which is in the ratio of 9:1 in favour of China. Now if a significant appreciation in Yuan takes place they may change their sourcing pattern with a distinct focus on India. Putting all your eggs in one basket is always dangerous. It is up to the Indian manufacturers to take advantage of the current situation and offer significant quality and price advantages to global entities.