Rama Krishna Vadlamudi, BOMBAY April 17, 2010

The controversy surrounding the revaluation of Chinese currency

Yuan has occupied the attention of the market players and politicians
in the last few months. The million-dollar question is: will they or won't
they – meaning whether China will allow its currency to appreciate
against the US dollar?

Two weeks back, American Treasury Secretary Tim Geithner

postponed releasing a Currency Report from the US Government. It
was expected that this report would dub China as a ‘currency
manipulator’ – triggering a trade war between China and America.
Such a trade war would have adverse implications for the world trade
and would send shock waves across the global financial markets. So,
what are the chances of such a panic reaction from the markets
happening in the next few quarters?
Let us try to examine the issue in detail:
 Rama Krishna Vadlamudi, BOMBAY April 17, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

THE SPAT BETWEEN PAUL KRUGMAN & STEPHEN ROACH:

China has kept the Yuan stable against the dollar since September 2008, when
Lehman Brothers collapse caused havoc in the financial markets across the
globe. Many Americans, including Nobel laureate in economics Paul Krugman,
believe that America should pressurize China to appreciate the Yuan. Those in
this ‘hard line’ camp argue that China is causing a lot of damage to the world
trade (read American economy) by keeping the Yuan pegged to the dollar
constantly. Krugman says that world economy is depressed by China artificially
keeping the Yuan undervalued. He avers Chinese mercantilist strategies have
important adverse implications for world economy. A few months back, a
Reuters’ Survey had put the undervaluation of Yuan at around 20 per cent,
meaning Yuan should have moved from the present 6.83 to around 5.50 per
dollar had China not halted its appreciation in September 2008 post-Lehman
Brothers collapse.

However, there are others who believe that America alone is responsible for its
twin deficits - both trade and fiscal. A respected financial expert Stephen Roach,
Morgan Stanley Asia chairman, argues that America should mind its own
business rather than blaming China for the woes of their own-making. He openly
crossed swords with Paul Krugman recently about the American strategy on
Yuan revaluation. A big problem for America is its lack of competitiveness.
If Yuan appreciates against the dollar, it will make Chinese exports to America
costlier. And this may help bridge the big trade deficit America has with China in
a limited way. America has got its own problems. For example, it has got huge
fiscal and trade deficits. And Chinese exchange rate policy is not responsible for
American mess which is self-created. Another thing is America is not a nation of
savers, like, Japan or Germany. Till recently, Americans had negative savings.
After the global financial meltdown, there is some upturn in savings from
American households.

CHINA IS WORLD’s FACTORY

China is a global manufacturing factory and is heavily dependent on its exports. Any
adverse impact on its exports will undermine its labour markets. China has to protect
its domestic economy from the ill-effects of the global financial meltdown. China’s
first priority is to protect the jobs of its domestic workers, in an effort to “maximize
export employment.” So, it has been playing very hard with its currency by not
allowing any appreciation against the US dollar. However, this has earned the wrath
of many of its trading partners. China’s export juggernaut continues to roll for the
time being. And China is not in a hurry to give in to any outside pressures and will
pursue its own exchange rate policy. China has become a superpower of sorts in its
own right and it has been flexing its muscles unabashedly. China usually does not
cave in to any interference or pressure from outside world.

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 Rama Krishna Vadlamudi, BOMBAY April 17, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

“Maosim did not succeed in China. Poverty

among the Chinese started getting alleviated K. Subramanyam,
only after Maoist doctrines were repudiated a defence expert
by Deng Xiaoping in 1989”

China has been enjoying huge trade surpluses (merchandise exports much
higher than imports) for several years. As a result of its long-running trade
surplus, China amassed huge foreign exchange reserves, which are at USD 2.45
trillion as at the end of March 2010 making China the world’s biggest holder of
foreign exchange reserves. In Indian rupee terms, China’s reserves are at Rs
109 lakh crore or almost nine times that of India’s reserves. India’s latest figures
show their foreign exchange reserves at Rs 12.4 lakh crore or USD 280 billion.
* (1 trillion = 1,000 billion or one lakh crore)

Paradoxically, out of this massive foreign exchange reserves of USD 2.45 trillion,
China has invested around USD 900 billion in US Government securities (or US
Treasurys). It is in the interest of both America and China not to escalate the
current controversy into a full-blown trade war. A trade war does not do any good
to either country. So, in the interest of world trade, these two countries shall
desist from any hawkish approach and try to look for some ‘soft’ approach in
resolving the current currency row.

DECLINGING AMERICAN INFLUENCE

Much of the diplomatic action in this regard would be behind the scenes.
Whatever position they may have taken in the public domain, the two countries
may pursue a wait-and-watch policy for the time being. China has almost
become a superpower after the demise of the erstwhile Soviet Union. The
balance of power has shifted from America toward Asia for the last several years.
The dominance of Asia, led by China, would continue for some more time.
America and China have recently slapped some tariffs each other on steel pipes
and other goods.
America has lost its legitimacy as a superpower, both economically and
politically, after a series of blunders (including American invasion of Iraq in 2003
and fighting the Taliban in Afghanistan, among others) during the regime of
George Bush between 2001 and 2008. America is no longer looked at with awe
by many. Now, Barack Obama is trying to regain some of the political sheen
America enjoyed for several decades. A few weeks back, he signed an
agreement with Russia in Prague for reduction of nuclear warheads – the plan
would cut their arms stockpile by one-third to 1,500 warheads each. Obama has
his own way of doing things. Even with regard to checking the nuclear arms
programme of Iran, he is trying to build a consensus with other leading countries.
However, for strategic reasons, China is supporting Iran diplomatically.

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 Rama Krishna Vadlamudi, BOMBAY April 17, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

TIMELINE OF THE CURRENCY CONTROVERSY

TIME EVENT

Sept.1985 Japan, the UK, Germany, France and America signed the Plaza Accord to
depreciate dollar against Japanese Yen and German Deutsche Mark by
intervention in currency markets

1995 China had pegged its currency to the dollar at 8.27 and it had remained at that level
till July 2005

1997 During the currency crisis in South Asia in 1997-98, which jolted the world's
financial markets severely, China stuck to its policy of stable peg to the dollar and
this helped the South Asian region to remain stable in times of adversity.

2001 America had started pressurizing China to revalue its domestic currency

July. 2003 Alan Greenspan, the then chairman of the US Fed, insisted that China must float
their currency, allow it to appreciate and, hopefully, help remove what is being seen
as the principal bottleneck to the smooth adjustment of the unsustainable US
balance of payments deficit

May.2005 The hawks in the US Congress expected that US Treasury would dub China as a
'currency manipulator'. But, the hawks were disappointed when the US Treasury did
not use the word at all in the report to the Congress. However, the US Treasury
issued a warning in its Currency Report that unless China reformed its exchange
rate, it would be liable for punitive steps.

July.21, Yuan was allowed to appreciate from 8.28 to 8.11 or 2.1% against dollar in a single
2005 day after Chinese central bank removed the dollar peg. Chinese Yuan switched to
managed float against a basket of currencies and the US Treasury was happy with
the Chinese deft move.

Sept.2008 China has reverted back to pegging its currency to the US dollar

Mar.2010 130 US senators urged the US Govt to take tougher action China for 'manipulating'
currency

April.2010 The US Treasury Secretary Tim Geithner delayed a Currency Report on Chinese
Yuan thus allowing China more time for a rethink on its currency policy

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 Rama Krishna Vadlamudi, BOMBAY April 17, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

CHINA EASED ITS CURRENCY POLICY IN JULY 2005

China eased its currency policy in July 2005. At that time, their central bank, the
People’s Bank of China, made it clear that it would ‘ease’ but not abandon its
traditional peg to the dollar. It had allowed a managed float for Yuan against a
basket of currencies of countries with which it trades. In July 2005, one US dollar
was fetching around 8.30 Yuan. With its managed float stance, the Yuan reached
a level of 6.83 to the dollar – indicating an 18 per cent appreciation of Yuan
against the dollar between July 2005 and September 2008.

Since the middle of September 2008, China reverted back to its traditional peg to
the US dollar. Many other Asian countries, including India, have allowed two-way
movement of their national currencies against the US dollar despite their own
economic problems. In fact, many Asian currencies have appreciated by 5 to 10
per cent against the dollar in the last six months even though dollar itself
appreciated against other major currencies, like, the Euro, Pound Sterling and
Yen. But, Chinese Yuan (or Renminbi) has been artificially kept within a range of
6.81 and 6.85 to the dollar between September 2008 and now. When Chinese
currency remains constant steadfastly against the US dollar, it makes exports
from other Asian exports less competitive. The non-appreciation of Yuan (while
other Asian currency continue to appreciate against the dollar) makes Chinese
exports more competitive.

JOSEPH STIGLITZ: No time for trade war

“Saudi Arabia’s trade surplus of USD 212 billion (11.5% of its GDP)
in 2008 dwarfs China’s USD 175 billion surplus (5% of its GDP), as a
percentage of GDP. China’s current account surplus is actually less
than that of Japan and Germany (5.2% of GDP). Then, why blame
China alone for American deficits?”

Thus said Joseph Stiglitz, Nobel Prize winner of economics, in an article

published in Economic Times dated April 16, 2010

CHINA AND AMERICA: SIAMESE TWINS?

Chinese economy is export-driven. As such, China tries to earn as much possible
from its exports, keeping their factories buzzing and in the process allowing the
safety of jobs for Chinese workers. By keeping its currency undervalued, China
wants to protect its job market at home. The recent USD 590-billion Chinese

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 Rama Krishna Vadlamudi, BOMBAY April 17, 2010
www.scribd.com/vrk100 vrk_100@yahoo.co.in
MY BLOG: www.ramakrishnavadlamudi.blogspot.com

stimulus failed to create new jobs in China – instead the massive bank credit
offtake helped only capital-intensive heavy industries. It is difficult for any
country to make China agree for appreciation of its domestic currency. American
dominance in world affairs has come down drastically in the last decade. In 1985,
under the leadership of Ronald Reagan, America had arm-twisted, through the
Plaza Accord, Japan and Germany (then West Germany) to allow their domestic
currencies to raise against dollar. The Plaza Accord facilitated America to reduce
its trade deficit with these countries to some extent. Experts have opined that the
Plaza Accord had disastrous consequences for Japanese economy, which has
been on a steady decline since 1989.

But the situation now is completely different. America is not in a position to

coerce China on changing its exchange rate policy. China has for long argued
that America should reassure them safety of their investments in US Treasurys
and other dollar assets. Recently, China expressed its concern over the steep fall
of dollar against major currencies. They have suggested that the world needs to
replace the dollar with another reserve currency, which has been endorsed by
other countries. However, it is difficult to believe that China will push for an
alternative reserve currency very hard as its economy is closely dovetailed to the
American economy. The American consumer spending had fed export-oriented
Chinese economy for decades. In turn, China has been responsible for bridging
up the massive budget deficits of the US by investing its (China’s) foreign
exchange reserves in the US Treasurys. China’s foreign exchange reserves have
helped America to raise money at cheaper rates. That way, the economies of the
US and China are conjoined twins. Both China and America have pursued
policies that best suit their interests.

Of course, the dollar has appreciated by about 10 per cent against major
currencies in the last five months easing the Chinese concerns on the safety of
their investments in US Treasurys. On its part, China needs to reorient and
rebalance its economy from export-driven to domestic consumption-led, like the
way India has been doing now. All indications at this point of time show that in
the next year China would definitely allow Yuan’s appreciation of around 4 to 6
per cent with a caveat that they would do it at their own pace and convenience.

If America and China decide to go for a full-blown trade war, this would have
disastrous consequences for world trade – which would send the stock markets
into a jittery phase and the indices may fall sharply in a matter of few days if not
hours.

Piicture courtesy: PBOC, US Treasury

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