Why yuan cannot replace dollar for int'l tradeLast 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 International

Institute for Strategic Studies, at its Bahrain office earlier this month, I was

somewhat surprised that China got as much talk time at the conference as

the European currency.

There seemed to be two issues related to China that appeared to bother the

conference participants - a motley mix of politicians, international

bureaucrats, economists, defence analysts and bankers.First, the kind of

strategic power that China's large holding of dollar reserves endows it with.

Second, the consequences of China's bid for rapid "internationalisation" of

its currency, the renminbi.

Let's get to the first issue, which has been debated widely over the last few

years. Is China's dollar reserve holding indeed a serious threat for the US?

Is there a risk of US 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.

Indeed the converse might actually be true - the fact that the US is

a large debtor gives China reason to handle it with caution.

As economist John Williamson 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 US. ...As Keynes once

observed, when I owe my bank a thousand dollars, I have reason to

fear my banker; if I 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 11 per cent

share in global trade. This dominance in trade could give its effort

some traction. But first things first: what exactly does

internationalisation mean? It could simply mean more trade and

investment transactions are billed directly in the yuan (RMB).

Thus, say, an Indian company importing a machine from China

could ask for a price quote in RMB instead of dollars and be able to

execute the transaction by directly exchanging RMB for rupees.

(Currently the company would have to do a three-leg transaction,

buying dollars for rupees and then RMB for dollars).

This would be the most basic internationalisation, and it has

progressed considerably with a number of East Asian economies

using the yuan extensively.

The most extreme form of internalisation would be to make RMB a

major reserve currency that sovereign governments would hold

their surpluses in.

It is not entirely clear that it would be in China's interest for RMB to

emerge as a reserve currency. Reserve currency status effectively entails a

loss of control over the exchange rate, and for a country that has long been

accustomed to managing the exchange rate, this could be somewhat

difficult to accept.

However, for China, many of their economic aspirations stem from the need

to make power statements rather than the balance of costs and benefits.

Significant international holdings of RMB 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 exchange rate

is managed. Neither of these things is easy to abandon in a hurry.

While it is true that China has made the RMB more flexible over the last

couple of years (it is at a 19-year high currently), it is far from being a free

float. Besides, 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.

Besides, a robust currency market cannot exist in isolation; it needs the

support of free and flexible 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 question is: does it

really have the incentive to do so?

It 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 exports and investments.

Deeper financial markets could encourage households to leverage

their future incomes to finance consumption.

It 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.

But China has another problem. Its first shot at rebalancing the

economy that effectively commenced in the mid-2000s has been

somewhat tardy. The share of investment in national income

continued to rise at least until 2011.

A significant portion of this would involve banks and other lending

agencies lending extensively to unviable "zombie" investment

projects. 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 quo in the financial

sector.

These are some of the contradictions that China needs to resolve on

the path to internationalisation. Unless it does this successfully, the

renminbi is unlikely to emerge as a store of global value.

Know all about China's new currency policyLast updated on: August 31, 2011 11:08 IST

China's government may be about to

let the renminbi-dollar exchange rate

rise more rapidly in the coming months

than it did during the past year.

The exchange rate was actually frozen

during the financial crisis, but has been

allowed to increase since the summer of 2010.

In the past 12 months, the renminbi strengthened by 6 per cent

against the dollar, its reference currency.

A more rapid increase of the renminbi-dollar exchange rate would

shrink China's exports and increase its imports. It would also allow

other Asian countries to let their currencies rise or expand their

exports at the expense of Chinese producers.

That might please China's neighbours, but it would not appeal to

Chinese producers. Why, 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 policy: 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 existing portfolio of some $1.6 trillion worth of dollar bonds

and other foreign securities exposes it to two distinct risks:

inflation in the United States and Europe, and a rapid devaluation

of the dollar relative to the euro and other currencies.

Inflation in the US or Europe 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.

Even 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

European and other products.

The Chinese can reasonably worry about that after seeing the

dollar fall 10 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. But China

cannot reduce the volume of such bonds while it is running a large

current-account surplus.

During the past 12 months, China had a current-account surplus of

nearly $300 billion, which must be added to China's existing

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 expressed in renminbi.

A barrel of oil might still cost $90, but a 10 per cent increase in the

renminbi-dollar exchange rate reduces the renminbi price by 10 per

cent.

Reducing the cost of imports is significant because China imports a

wide range of consumer goods, equipment and raw materials.

Indeed, China's total annual imports amount to roughly $1.4

trillion, or nearly 40 per cent of gross domestic product (GDP).

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 12th Five-Year Plan is to

increase household incomes and consumer spending at a faster rate

than that of GDP growth.

The combination of faster household-spending growth and the

existing level of exports would cause production bottlenecks and

strain capacity, leading to faster increases in the prices of

domestically produced goods.

Making room for increased consumer spending requires reducing

the level of exports by allowing the currency to appreciate.

Looking back on the past year, the 6 per cent rise in the renminbi-

dollar exchange 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 6.5 per cent over the past

year, while US consumer prices rose only about 3.5 per cent.

The three-percentage-point difference implies that the "real"

inflation-adjusted renminbi-dollar exchange rate rose 9 per cent

over the past year (that is, 6 per cent nominal appreciation plus the

3 per cent inflation difference.)

Although this is how governments calculate real exchange-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

exported to the US may not have increased at all.

The renminbi-dollar exchange rate is, of course, only part of the

story of what drives China's trade competitiveness. While the

renminbi has risen relative to the dollar, the dollar has declined

against other major currencies.

The dollar's 10 per cent decline relative to the euro over the past

12 months implies that the renminbi is actually down by about 4

per cent relative to the euro.

The Swiss franc has increased more than 40 per cent against the

dollar - and therefore more than 30 per cent against the renminbi.

Looking at the full range of countries with which China trades

implies that the overall value of the renminbi probably declined in

the past 12 months.

The dollar is likely to continue falling relative to the euro and other

currencies over the next 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. Copyright: Project Syndicate, 2011.

Why China keeps its currency undervaluedLast updated on: June 22, 2010 14:04 IST

Equity markets across

the world made

handsome gains after

China announced plans to

make its currency, the

yuan, more flexible

against the dollar. China

on Saturday said it would

allow its currency to

appreciate against the US

dollar.

Market 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 Euro crisis.

In a statement on Saturday, China's central bank said: "In 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 Bank of China has decided to proceed further with

reform of the RMB exchange rate regime and to enhance the RMB

exchange rate flexibility."

So why is this such a big deal? And why are some economists still

sceptical about the goodness of the Chinese move? But more

importantly why does China deliberately keep its currency

undervalued?

Some economists feel that China's deliberately undervalued

currency costs India billions of dollars annually in growth. Other

world economies, like the United States, are even worse hit.

Currency manipulation is one of the schemes which China has used

to give their exports an unfair advantage. A recent report by the

Economic Policy Institute in the US found that an increasing trade

deficit to China, a decrease in US export capacity to China and

mounting foreign debt have caused $2.4 million jobs to be lost or

displaced.

Beijing uses currency manipulation to maintain the value of its

currency, the yuan, at an artificially low value, which makes its

exports much cheaper and its imports more expensive.

China keeps its currency (yuan) undervalued with respect to the US

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.

Exports are the Chinese engine of growth. The lower the value of

the yuan, the more advantageous the situation is for Chinese

exporters. So today if one dollar is equal to 7 yuans and a Chinese

exporter sells a shirt for 10 dollars, he gets 70 yuans. However, if

the value of one dollar were to be only 5 yuans (after the yuan is

allowed to reach its real value), the exporter would only get 50

yuans. Thus, to give its exporters an unfair advantage in the world

market, Beijing has lept the yuan undervalued.

China has already flooded various markets -- including the Indian

market -- with cheap goods as its artificially undervalued currency

makes its exporters very cost-competitive. If 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 undervalued?

Some economists think the yuan is undervalued by 20%. Some say

that the figure ranges from 15% to 40%. However, no one can say

for certain to what extent is the yuan undervalued.

However, when a currency is kept undervalued it leads to inflation

and China has experienced high inflation lately.

Impact of Chinese move on India

Indian exporters like textiles firms and toymakers expect that a

higher yuan can make India's cheaply made goods more attractive

to large markets like the United States and the European Union

and thus boost their business.

The Reserve Bank of India is evaluating the impact on the rupee

and its economy of China's announcement of limited currency

reform. China is one of India's largest trading partners, enjoying a

$15.2-billion trade surplus in April-December 2009.

CII director general Chandrajit Banerjee, in a statement said:

"Beijing's announcement over the weekend to proceed further with

exchange rate reforms and make yuan more flexible is a welcome

news for India and the global economy. However, it remains to be

seen how fast would China allow yuan to appreciate."

The extent to which Indian industry would benefit from the news

would depend on the degree of yuan's appreciation, Banerjee

added.

"Given China's important role in global economy and the world

trade, we welcome the announcement by Chinese authorities. We

expect Indian exporters of textiles, chemicals and light engineering

goods to benefit from such a move," he added. However, Banerjee

stressed that China getting closer to a market-oriented economy is

the best situation.

China's move to allow a more flexible exchange 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.

Some economists sceptical about Chinese move

China's exports surged by 48. 5 per cent year on year in May. This

triggered speculation that the much awaited reform of its currency,

yuan, against the US dollar was round the corner.

In value terms exports totalled $131.76 billion in May, while

imports totalled $112.23 billion. The US and the EU accuse China

of making windfall profits out of its exports by pegging its currency

deliberately low that makes its exports cheaper.

However, Religare Capital Markets Ltd chief economist Jay

Shankar had this to say on China's move and its impact: "China's

decision to make the yuan more flexible this weekend is unlikely to

lead to anything akin to one-off revaluation. The real test will be, as

also noted by the US treasury secretary Timothy Geithner, how far

and how fast the Chinese authorities allow the currency appreciate.

"We believe the let-off will be very gradual and token in nature. The

expected global rally in equity as well as commodity markets,

because of the Chinese actions, is unlikely to last long.

"The Chinese move should be seen as Beijing's attempt at telling

the world that they are as well contributing towards helping

rebalancing the global economy, ahead of the G8 and G20 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. We

believe that this is a move presented by Beijing as to pacify G8 and

G20 leaders and an attempt to tone down criticisms of Chinese

currency policy likely to be on the agenda of the meets."

But why is China's move on yuan significant? Read on. . .

Business Standard

Why China's move is significant

In 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. It is, therefore, no coincidence that the move comes roughly a week before the G20 summit in Toronto where pressure on China to adopt a more flexible currency regime was expected to intensify.

China has clearly pre-empted some of this by agreeing to more exchange flexibility.  However, this move is unlikely to mean any dramatic change, at least in the near term. While China has committed to dropping its de facto dollar peg (6.83 yuan to the greenback) that it has maintained since mid-2008, it has not promised either a one-off revaluation against the dollar or a free-floating currency. It 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 relaxing its exchange rate regime. It had abandoned its dollar peg in 2005 and moved to a managed float against a basket that included the euro and the yen.

In roughly the three years that this mechanism operated, the yuan appreciated by 21 per cent against the dollar. This might be some indication of how much appreciation is likely in the near to medium term.

Gestures 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 flexibility 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. Once this initial euphoria abates, there are a couple of issues that markets are likely to grapple with.

But will China puts its money where its mouth is?. . . Read on. . .

China's growth model has been dependent heavily on exports that,

in turn, have fed off an undervalued exchange rate.

Greater exchange rate flexibility could dent exports 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

exploit its domestic demand (particularly consumption) base.

If growth shows signs of flagging, financial markets (particularly

those for commodities where China is seen as the key demand

driver) could sell off. It could also resurrect fears of another dip in

growth. Besides, China is the principal creditor to the rest of the

world, particularly the US and Europe where it deploys its one

trillion dollars of foreign exchange reserves in government and

quasi-government bonds.

This stockpile of reserves is the result of its exchange rate policy.

Its central bank has bought dollars and euros relentlessly to cap

the yuan's exchange rate.

A flexible exchange rate regime would reduce the Chinese central

bank's need to intervene in the market and could thus reduce its

stock of foreign exchange reserves, or at least slow down the pace

of accretion. Its appetite for dollar and euro bonds will wane as a

result.

For western governments that are likely to see large budget deficits

and consequently supply large quantities 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 G7 countries will tend to rise

sharply. That could keep markets and policy-makers on edge. All in

all, the yuan flexibility story has to play itself out fully before

markets can rush to judgment.

While this weekend's news may win some comfort for Beijing, next

weekend in Toronto the world will wait to see if China puts its

money where its mouth is.