Chinese currency and its effects on Global Economy

China has once again proven its mettle. The Bull cannot be bullied.

The Group of Seven industrialised nations might have thought that they can extract a promise from China's minister of finance Jin Renqing to revalue the yuan or let it float freely. But their efforts were in vain.

China is as strong as ever in its conviction to wait till the infrastructure and the brainpower is ready to support a free-floating currency in the country.

What is beyond comprehension is, instead of asking China to revalue yuan, why not take a re-look at the huge current account deficit of the United States, a staggering $164.7 billion in the third quarter of last year, and find ways to solve that issue!

The G7 nations make it sound as though an undervalued Yuan is the only cause for all the woes of their economies. But, as we read on, we see that though it may not be the only cause all their woes, it definitely is a big one.

China has been riding the big waves of growth at an envious 9 per cent plus rate of growth in the last two decades. It is all set to become an economic superpower in the years to come.

The world markets are flooded with China manufactured products, boosting the manufacturing industry in China, hence exports. One reason for this growth in exports has also been the pegged currency of China. China pegged its currency to the dollar in 1994, at 8.24 yuans per dollar.

Analysts claim that now the yuan is as much as 40 per cent undervalued. While the dollar continues to weaken, the Chinese exporters are taking advantage of the peg and growing by leaps and bounds.

On the other hand, the other G7 countries are facing the brunt of the depreciating dollar, making their exports expensive. Adding to the misery is the realisation that poorer countries like China and India are financing their ever-increasing current account deficits.

Central banks of countries like China and India, who are experiencing a huge inflow of dollars in their economies, are buying up the dollars to maintain the demand of dollars, and investing them in US Treasury backed securities like Treasury Bonds and Notes.

This has led to low yields on these assets having an effect on many industrialized nations who hold huge numbers of these assets. Hence the pressure on China to revalue the yuan, so that it will not need to buy back as many dollars, and in turn will not need to invest them in US treasury assets.

This will drive down the demand for these assets, reducing their price and increasing their yield. So much for the Chinese policy on the yuan!

India is another country which is making its presence felt at many of the similar forums like the G7 meet. The fact that it was invited to the G7 meet itself is a proof. Finance Minister P Chidambaram proclaimed his support for flexible exchange rate regimes and India's commitment to globalisation.

This when the Reserve Bank of India has been actively engaged in the sterilisation of dollars to prevent the Rupee from appreciating!

The RBI's policy of buying up the dollars to keep the rupee from appreciating rapidly seems fair enough when looked at from the exporters point of view. India competes with China in many sectors directly; say textiles and steel to name a few.

Now given that the yuan is pegged to the dollar, letting the rupee appreciate will reduce the price competitiveness of the Indian exporters.

But when looked at from the other angle, India being a growing economy, its imports are all poised to increase in the future, with increased investment in technology, infrastructure and development related projects.

Also, a lot of India's exports have a huge import content to it and gains on these imports would cover the loss on the export of the final product to a great extent, if the rupee were allowed to appreciate freely.

One challenge before the government would be to liberalise the imports in such a way so that benefit can be taken of the appreciating rupee without jeopardizing certain sectors, which can be badly hurt from competing imported products.

Liberalising imports can not only create greater demand for dollars, but also boost developmental activities in India.

So far, RBI has chosen to protect exporters over liberalising the imports. Now many exporters in India claim that even if the rupee were to appreciate further -- Chinese exporters claim the same in case of an appreciation of yuan -- their products would still be competitive due to their quality.

If this is the case, then letting the rupee appreciate should not be very damaging to the exporters. Another point in favour of the exporters is the growing derivatives market in India, which gives an avenue to the exporters to manage the risk due to an appreciating rupee.

One thing is for sure: not only are the industrialised nations keeping their fingers crossed that China will revalue the yuan, even India is keenly watching China in this regard.

And it is to India's benefit to support the G7 nations in asking China to revalue the yuan. RBI's move towards further liberalisation of the economy can depend to a large extent on any move by China towards this step.

Chidambaram rightly gave his support to the G7 nations by commenting: "The consensus among economists is that flexible exchange rates are an important factor of strength in the macro policy framework."

The point to be emphasised is that both China and India are growing very fast. There is a feel good factor about both these countries. Governments need to make sure that this growth is matched by right and timely investment in technology and infrastructure or else the countries will not be ready to handle the growth after some point of time.

Foreign investors already complain of the legal and investment environment in the both the countries. The only way to go is up. Any further decline in these aspects could prove too expensive for all the stakeholders.

The author is Research Scholar, ICFAI University and currently a Visiting Research Scholar at Syracuse University, NY.