Why yuan cannot replace dollar for int'l trade

Last updated on: November 1, 2012 10:58 IST

Abheek Barua, chief economist at HDFC Bank, explains why China's renminbi is a long way from becoming a global reserve currency

There is a common assumption these

days that any discussion on currencies would be dominated by the future of the euro and the euro zone. Attending the conference themed "Currencies of Power and the Power of Currencies", organised by a heavyweight think tank, the nternational nstitute for !trategic !tudies, at its "ahrain office earlier this month, was somewhat surprised that China got as much talk time at the conference as the #uropean currency. There seemed to be two issues related to China that appeared to bother the conference participants $ a motley mi% of politicians, international bureaucrats, economists, defence analysts and bankers.&irst, the kind of strategic power that China's large holding of dollar reserves endows it with. !econd, the conse(uences of China's bid for rapid "internationalisation" of its currency, the renminbi. )et's get to the first issue, which has been debated widely over the last few years. s China's dollar reserve holding indeed a serious threat for the *!+ s there a risk of *! interest rates skyrocketing if China were to suddenly sell off a hefty portion of reserves+ The problem with the alarmists' arguments that raise this China bogey is that they fail to recognise the fact that it is against its interest to shift away from dollars. Any effort by China to sell a significant proportion would lead to a sharp depreciation of the dollar and that would entail a large loss for all dollar holders including China. Thus, it would be irrational for China to shoot itself in the foot by shifting its reserves away from the greenback.

ndeed the converse might actually be true $ the fact that the *! is a large debtor gives China reason to handle it with caution. As economist ,ohn -illiamson argued at the conference, "far more credible is the fact that the balances .China's dollar reserves/ act as a restraining influence on any Chinese inclination to engage in acts that would be regarded as hostile to the *!. ...As 0eynes once observed, when owe my bank a thousand dollars, have reason to fear my banker1 if owe it a million, he fears me". There is much less clarity on where the effort to "internationalise" the renminbi is headed. China is the biggest trader in the world, with about an 22 per cent share in global trade. This dominance in trade could give its effort some traction. "ut first things first3 what e%actly does internationalisation mean+ t could simply mean more trade and investment transactions are billed directly in the yuan .45"/. Thus, say, an ndian company importing a machine from China could ask for a price (uote in 45" instead of dollars and be able to e%ecute the transaction by directly e%changing 45" for rupees. .Currently the company would have to do a three$leg transaction, buying dollars for rupees and then 45" for dollars/. This would be the most basic internationalisation, and it has progressed considerably with a number of #ast Asian economies using the yuan e%tensively. The most e%treme form of internalisation would be to make 45" a ma6or reserve currency that sovereign governments would hold their surpluses in.

t is not entirely clear that it would be in China's interest for 45" to emerge as a reserve currency. 4eserve currency status effectively entails a loss of control over the e%change rate, and for a country that has long been accustomed to managing the e%change rate, this could be somewhat difficult to accept.

7owever, for China, many of their economic aspirations stem from the need to make power statements rather than the balance of costs and benefits. !ignificant international holdings of 45" as reserves would be one such assertion of power. That said, there could be impediments to internationalisation beyond a point. To start with, the capital account is controlled and the e%change rate is managed. 8either of these things is easy to abandon in a hurry. -hile it is true that China has made the 45" more fle%ible over the last couple of years .it is at a 29$year high currently/, it is far from being a free float. "esides, Chinese policy makers have in the past shown a penchant to fall back on time$tested policies at the first sign of any serious trouble on the economic front. Thus, the possibility of China suddenly reverting to a de facto currency peg is not negligible, and potential holders of the renminbi have to bear in mind this risk. "esides, a robust currency market cannot e%ist in isolation1 it needs the support of free and fle%ible financial markets, particularly the money and bond markets.

China might have undertaken financial sector reform over the past few years,
but much more needs to be done. The (uestion is3 does it really have the incentive to do so+ t is possible to argue that financial sector reforms would help the process of internal rebalancing that it has embarked on. This entails a shift away from e%ports and investments. :eeper financial markets could encourage households to leverage their future incomes to finance consumption. t would also help improve the return on savings, create products that insure against contingencies and reduce the volume of "precautionary savings" that households hold to insure against contingencies. This could raise the share of consumption in the economy.

"ut China has another problem. ts first shot at rebalancing the economy that effectively commenced in the mid$;<<<s has been somewhat tardy. The share of investment in national income continued to rise at least until ;<22. A significant portion of this would involve banks and other lending agencies lending e%tensively to unviable "zombie" investment pro6ects. This would have added to the amount of impaired loans that are known to be sitting on the books of Chinese lenders. To prevent an implosion in the financial sector, China needs to ensure that the savings rate remains high and real interest low. This creates an incentive to retain the status (uo in the financial sector. These are some of the contradictions that China needs to resolve on the path to internationalisation. *nless it does this successfully, the renminbi is unlikely to emerge as a store of global value.

Know all about China's new currency policy

Last updated on: August 31, 2011 11:08 IST

China's government may be about to let the

renminbi$dollar e%change rate rise more rapidly in the coming months than it did during the past year. The e%change rate was actually frozen during the financial crisis, but has been allowed to increase since the summer of ;<2<. n the past 2; months, the renminbi strengthened by = per cent against the dollar, its reference currency. A more rapid increase of the renminbi$dollar e%change rate would shrink China's e%ports and increase its imports. t would also allow other Asian countries to let their currencies rise or e%pand their e%ports at the e%pense of Chinese producers. That might please China's neighbours, but it would not appeal to Chinese producers. -hy, then, might the Chinese authorities deliberately allow the renminbi to rise more rapidly+

There

are two fundamental reasons the

Chinese government might choose such a policy3 reducing its portfolio risk and containing domestic inflation. Consider, first, the authorities' concern about the risks implied by its portfolio of foreign securities.

China's e%isting portfolio of some >2.= trillion worth of dollar bonds and other foreign securities e%poses it to two distinct risks3 inflation in the *nited !tates and #urope, and a rapid devaluation of the dollar relative to the euro and other currencies. nflation in the *! or #urope would reduce the purchasing value of the dollar bonds or euro bonds. The Chinese would still have as many dollars or euros, but those dollars and euros would buy fewer goods on the world market.

#ven

if there were no increase in

inflation rates, a sharp fall in the dollar's value relative to the euro and other foreign currencies would reduce its purchasing value in buying #uropean and other products. The Chinese can reasonably worry about that after seeing the dollar fall 2< per cent relative to the euro in the past year $ and substantially more against other currencies. The only way for China to reduce those risks is to reduce the amount of foreign$currency securities that it owns. "ut China cannot reduce the volume of such bonds while it is running a large current$account surplus. :uring the past 2; months, China had a current$account surplus of nearly >?<< billion, which must be added to China's e%isting holdings of securities denominated in dollars, euros and other foreign currencies.

The second reason China's political leaders might favour a stronger renminbi
is to reduce China's own domestic inflation rate. A stronger renminbi lowers the cost to Chinese consumers and Chinese firms of imported products as e%pressed in renminbi.

A barrel of oil might still cost >9<, but a 2< per cent increase in the renminbi$ dollar e%change rate reduces the renminbi price by 2< per cent. 4educing the cost of imports is significant because China imports a wide range of consumer goods, e(uipment and raw materials. ndeed, China's total annual imports amount to roughly >2.@ trillion, or nearly @< per cent of gross domestic product .A:P/. A stronger renminbi would also reduce demand pressure more broadly and more effectively than the current policy of raising interest rates.

This will be even more important in the future as China carries out its plan to
increase domestic spending, especially spending by Chinese households. A principal goal of the recently presented 2;th &ive$Bear Plan is to increase household incomes and consumer spending at a faster rate than that of A:P growth. The combination of faster household$spending growth and the e%isting level of e%ports would cause production bottlenecks and strain capacity, leading to faster increases in the prices of domestically produced goods. 5aking room for increased consumer spending re(uires reducing the level of e%ports by allowing the currency to appreciate.

)ooking

back on the past year, the = per cent rise in the renminbi$dollar

e%change rate might understate the increase in the relative cost of Chinese goods to American buyers because of differences in domestic inflation rates. Chinese consumer prices rose about =.C per cent over the past year, while *! consumer prices rose only about ?.C per cent. The three$percentage$point difference implies that the "real" inflation$ ad6usted renminbi$dollar e%change rate rose 9 per cent over the past year .that is, = per cent nominal appreciation plus the ? per cent inflation difference./

Although this is how governments calculate real e%change$rate changes, it no

doubt overstates the relative change in the prices of the goods that Americans buy from China, because much of China's inflation was caused by rising prices for housing, local vegetables and other non$tradables. The renminbi prices of the Chinese manufactured products that are e%ported to the *! may not have increased at all. The renminbi$dollar e%change rate is, of course, only part of the story of what drives China's trade competitiveness. -hile the renminbi has risen relative to the dollar, the dollar has declined against other ma6or currencies.

The dollar's 2< per cent decline relative to the euro over the past 2; months
implies that the renminbi is actually down by about @ per cent relative to the euro. The !wiss franc has increased more than @< per cent against the dollar $ and therefore more than ?< per cent against the renminbi. )ooking at the full range of countries with which China trades implies that the overall value of the renminbi probably declined in the past 2; months. The dollar is likely to continue falling relative to the euro and other currencies over the ne%t several years. As a result, the Chinese will be able to allow the renminbi to rise substantially against the dollar if they want to raise its overall global value in order to decrease China's portfolio risk and rein in inflationary pressure. The author is professor of Economics at Harvard, was chairman of President Ronald Reagan's Council of Economic Advisers and is former president of the National Bureau for Economic Research . Cop right! Pro"ect # ndicate, $%&&'

Why China keeps its currency undervalued

Last updated on: June 22, 2010 14:04 IST

#(uity

markets across the

world made handsome gains after China announced plans to make its currency, the yuan, more fle%ible against the dollar. China on !aturday said it would allow its currency to appreciate against the *! dollar. 5arket analysts said China's move would go a long way in lifting the global economic sentiment that has been under the weather due to the #uro crisis. n a statement on !aturday, China's central bank said3 " n view of the recent economic situation and financial market developments at home and abroad, and the balance of payments situation in China, the People's "ank of China has decided to proceed further with reform of the 45" e%change rate regime and to enhance the 45" e%change rate fle%ibility." !o why is this such a big deal+ And why are some economists still sceptical about the goodness of the Chinese move+ "ut more importantly why does China deliberately keep its currency undervalued+

!ome

economists feel that China's deliberately undervalued currency costs

ndia billions of dollars annually in growth. Dther world economies, like the *nited !tates, are even worse hit.

Currency manipulation is one of the schemes which China has used to give their e%ports an unfair advantage. A recent report by the #conomic Policy nstitute in the *! found that an increasing trade deficit to China, a decrease in *! e%port capacity to China and mounting foreign debt have caused >;.@ million 6obs to be lost or displaced. "ei6ing uses currency manipulation to maintain the value of its currency, the yuan, at an artificially low value, which makes its e%ports much cheaper and its imports more e%pensive. China keeps its currency .yuan/ undervalued with respect to the *! dollar by buying dollars in the open market. China, which runs a huge trade surplus, can afford to buy dollars in the open market to keep the demand for dollars high, and push the dollar price upwards relative to the yuan. This keeps the yuan undervalued.

#%ports are the Chinese engine of growth. The lower the value of the yuan, the
more advantageous the situation is for Chinese e%porters. !o today if one dollar is e(ual to E yuans and a Chinese e%porter sells a shirt for 2< dollars, he gets E< yuans. 7owever, if the value of one dollar were to be only C yuans .after the yuan is allowed to reach its real value/, the e%porter would only get C< yuans. Thus, to give its e%porters an unfair advantage in the world market, "ei6ing has lept the yuan undervalued. China has already flooded various markets $$ including the ndian market $$ with cheap goods as its artificially undervalued currency makes its e%porters very cost$competitive. f the value of the yuan were to appreciate, Chinese goods would no longer be cheap enough to compete with goods produced locally in these markets that China invades. By how much is the yuan un!ervalue!"

!ome economists think the yuan is undervalued by ;<F. !ome say that the figure ranges from 2CF to @<F. 7owever, no one can say for certain to what e%tent is the yuan undervalued. 7owever, when a currency is kept undervalued it leads to inflation and China has e%perienced high inflation lately.

#mpact of Chinese move on #n!ia ndian e%porters like te%tiles firms and toymakers e%pect that a higher yuan can make ndia's cheaply made goods more attractive to large markets like the *nited !tates and the #uropean *nion and thus boost their business. The 4eserve "ank of ndia is evaluating the impact on the rupee and its economy of China's announcement of limited currency reform. China is one of ndia's largest trading partners, en6oying a >2C.;$billion trade surplus in April$ :ecember ;<<9. C director general Chandra6it "aner6ee, in a statement said3 ""ei6ing's announcement over the weekend to proceed further with e%change rate reforms and make yuan more fle%ible is a welcome news for ndia and the global economy. 7owever, it remains to be seen how fast would China allow yuan to appreciate." The e%tent to which ndian industry would benefit from the news would depend on the degree of yuan's appreciation, "aner6ee added. "Aiven China's important role in global economy and the world trade, we welcome the announcement by Chinese authorities. -e e%pect ndian e%porters of te%tiles, chemicals and light engineering goods to benefit from such a move," he added. 7owever, "aner6ee stressed that China getting closer to a market$oriented economy is the best situation. China's move to allow a more fle%ible e%change rate for the yuan could hurt Chinese manufacturers who sell abroad.

The move could also boost purchasing power and consumer demand in China. A higher yuan will also lead to controlling inflation in China as import prices will do down.

$ome economists sceptical about Chinese move

China's e%ports surged by @G. C per cent year on year in 5ay. This triggered
speculation that the much awaited reform of its currency, yuan, against the *! dollar was round the corner. n value terms e%ports totalled >2?2.E= billion in 5ay, while imports totalled >22;.;? billion. The *! and the #* accuse China of making windfall profits out of its e%ports by pegging its currency deliberately low that makes its e%ports cheaper. 7owever, 4eligare Capital 5arkets )td chief economist ,ay !hankar had this to say on China's move and its impact3 "China's decision to make the yuan more fle%ible this weekend is unlikely to lead to anything akin to one$off revaluation. The real test will be, as also noted by the *! treasury secretary Timothy Aeithner, how far and how fast the Chinese authorities allow the currency appreciate. "-e believe the let$off will be very gradual and token in nature. The e%pected global rally in e(uity as well as commodity markets, because of the Chinese actions, is unlikely to last long. "The Chinese move should be seen as "ei6ing's attempt at telling the world that they are as well contributing towards helping rebalancing the global economy, ahead of the AG and A;< meet, scheduled towards the end of this week. "The Chinese decision will have to be seen with action on the ground, as to how much appreciation of yuan will be allowed. -e believe that this is a move presented by "ei6ing as to pacify AG and A;< leaders and an attempt to tone

down criticisms of Chinese currency policy likely to be on the agenda of the meets." "ut why is China's move on yuan significant+ %ea! on Business $tan!ar! &hy China's move is significant n the world of economic diplomacy where gestures often mean much more than concrete action, China's move to abandon its currency peg against the dollar is significant. t is, therefore, no coincidence that the move comes roughly a week before the A;< summit in Toronto where pressure on China to adopt a more fle%ible currency regime was e%pected to intensify. China has clearly pre$empted some of this by agreeing to more e%change fle%ibility. 7owever, this move is unlikely to mean any dramatic change, at least in the near term. -hile China has committed to dropping its de facto dollar peg .=.G? yuan to the greenback/ that it has maintained since mid$ ;<<G, it has not promised either a one$off revaluation against the dollar or a free$floating currency. t will continue to "manage" its currency through heavy intervention by its central bank. Thus, a sharp appreciation in the yuan against the dollar is unlikely. This is incidentally not the first time that China is rela%ing its e%change rate regime. t had abandoned its dollar peg in ;<<C and moved to a managed float against a basket that included the euro and the yen. n roughly the three years that this mechanism operated, the yuan appreciated by ;2 per cent against the dollar. This might be some indication of how much appreciation is likely in the near to medium term. Aestures are important to financial markets as well, and the implication of China's move is being analysed threadbare by financial analysts across the world. The immediate response has been to read the move to allow fle%ibility as proof of the Asian behemoth's confidence in its own economic recovery.

China's stock market has risen, pulling other markets in the region up along with it. Asian currencies, including the rupee, have moved up. Dnce this initial euphoria abates, there are a couple of issues that markets are likely to grapple with. "ut will China puts its money where its mouth is+. . . %ea! on

China's growth model has been dependent heavily on e%ports that, in turn,
have fed off an undervalued e%change rate. Areater e%change rate fle%ibility could dent e%ports and the country's ability to sustain its scorching pace of growth is contingent on how much the economy has been able to and can e%ploit its domestic demand .particularly consumption/ base. f growth shows signs of flagging, financial markets .particularly those for commodities where China is seen as the key demand driver/ could sell off. t could also resurrect fears of another dip in growth. "esides, China is the principal creditor to the rest of the world, particularly the *! and #urope where it deploys its one trillion dollars of foreign e%change reserves in government and (uasi$government bonds. This stockpile of reserves is the result of its e%change rate policy. ts central bank has bought dollars and euros relentlessly to cap the yuan's e%change rate. A fle%ible e%change rate regime would reduce the Chinese central bank's need to intervene in the market and could thus reduce its stock of foreign e%change reserves, or at least slow down the pace of accretion. ts appetite for dollar and euro bonds will wane as a result. &or western governments that are likely to see large budget deficits and conse(uently supply large (uantities of bonds in the international markets, this could spell trouble unless the demand from their own households and companies compensates.

The risk is that interest rates in the AE countries will tend to rise sharply. That could keep markets and policy$makers on edge. All in all, the yuan fle%ibility story has to play itself out fully before markets can rush to 6udgment. -hile this weekend's news may win some comfort for "ei6ing, ne%t weekend in Toronto the world will wait to see if China puts its money where its mouth is.