Pegged to the present

Indian Express, 29 October 2010

India needs to rethink its position on the Chinese yuan policy. In addition to currency flexibility being in China's own interest, it is in India's interest if China shifts to an exchange rate regime with greater flexibility.

The debate on the Chinese yuan has heated up. G20 nations agreed to restrict current account imbalances at Seoul, but as everyone correctly understands, the real story is about currencies. Appreciation of the RMB is one of the most important levers through which the massive Chinese current account surplus will shrink. But China is clinging to its dollar peg.

What should India's policy on the Chinese exchange rate be? In the past, India has supported China, implicitly or explicitly. For many years, India also tried to follow the Chinese game, of buying dollars to force the rupee down. This was partly because of pressure from exporters and partly because of a belief in a growth strategy that focussed on subsidised exports as the engine of growth. The costs of this policy were not clear, and no one thought about what would happen if the markets to whom you were exporting went into a prolonged recession.

Before the crisis, Chinese currency pegging was seen as only a side story. While there were economists predicting that this could lead to a global crisis, nothing had happened. Today this view is much more mainstream. Once the crisis blew up, owing both to weak financial regulation by the US and global imbalances, the spotlight on the yuan policy increased. Apart from getting the blame for the large US current account deficit in the pre-crisis period, China's currency regime has become an issue in US debates on recession and employment. Distortionary policies the world over, in terms of trade barriers and capital controls, are being planned as a consequence of China's actions.

The G20 has been talking about global rebalancing, or a reduction in US current account deficits and in trade surpluses of the surplus countries. The US has no direct control over the value of the dollar. As long as the dollar is strong, US consumers will keep buying cheap Chinese goods, and the US will have large trade deficits. And, if China intervenes to keep the yuan weak and the dollar strong, and if other Asian economies follow China, the US deficit is unlikely to go away. If this means that employment and growth in the US will not recover and the world witnesses a prolonged recession, India will be a loser. It is in India's interest that the world economy recovers, even if it involves a slowing down of the Chinese economy.

Another change in the situation compared to before the crisis is that RBI has got out of attempts at trading on the currency market for nearly two years. India has learnt how to live with a flexible exchange rate in some of the most adverse times. Earlier, it would have been hypocritical for India to stand up in an international forum and sermonise to China on dismantling a pegged exchange rate regime. But having moved to a market rate itself, India can now take the stance that it is contributing its fair share to rebalancing of the world and China should do the same. In the post-financial crisis story of global rebalancing, China is a part of the problem and India is a part of the solution.

If the US Federal Reserve goes for further quantitative easing, it could imply more capital flowing into emerging economies. India is today one of the most attractive destinations for capital flows. The pressure on the rupee to appreciate and the consequent lobbying of the exports will increase. India has, in the past, witnessed difficulties that arise from intervening in foreign exchange markets. In the existing inflationary conditions this would be very risky, as it could push inflation up further. With the already large fiscal deficit, selling more government bonds to sterlise its intervention is going to be difficult for the RBI. While China can force banks to buy sterilisation bonds at low interest rates, this is not a feasible option in India. Partial sterilisation will increase liquidity and will contribute to inflation.

But that is only a part of the story. Another important lesson from the crisis is about the role of exports in a country's development strategy. Indian export markets saw huge downturns, but the economy did not suffer as much as it could have, had we been even more dependent on exports. The large share of domestic consumption, nearly 70 percent of GDP, bore well for the Indian economy. The fact that India had not chased the export led growth model, stood India in good stead. Had the country been excessively dependent on exports, then after the crash in the US economy, there would have been even more problems to grapple with than there are today.

Today it is not easy for China to move away from the dollar peg even if the leadership wishes to. The presence of large companies with profits and employment dependent on exports, reduces the political leadership's capacity to take decisions that would hurt these companies. China has followed an export led model for many decades. These interests are therefore powerful and entrenched in the Chinese economy. To the extent that China will move away from the peg due to the distortions that it creates in the Chinese economy, it is difficult to say how long the process will take. However, when it does, India stands to gain both from the direct effect of reduced competition from Chinese exports, and from improved world trade. If international coalitions help other Asian economies to stay away from the Chinese model, again, that will increase India's gains.

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