The revaluation of the Chinese yuan and the implications for India

Indian Express, 1 August 2005

What is the Chinese currency called?

The official name of the Chinese currency is the renminbi. But the way the British use the term 'Pound Sterling', the Chinese, in Chinese say, one yuan renminbi, or 8.1 yuan renminbi. In English both the "yuan" and "renminbi" are used interchangably to refer to the Chinese currency. Sometimes the abbreviation RMB is used. Currency markets usually use the abbreviation CNY.

What does "revaluation" of the yuan mean?

In the olden days, the value of a currency used to be measured in terms of gold. Less gold per rupee would mean the rupee was being devalued. Similarly, more gold per rupee meant that the rupee was being revalued. The term "strengthening" of the currency is also used in this context. The currency is stronger when it can buy more gold. It is weaker if it can buy less gold. Now the US dollar has replaced gold as the measure. The revaluation thus means the yuan is stronger, it can buy more dollars. Earlier one had to pay 8.28 yuan to buy a dollar, now one can do it in only 8.11 yuan.

Why do we say "revaluation" of the yuan, but "appreciation" of the rupee?

When the currency regime is such that the currency is allowed to move in response to market forces, a change in its value is referred to as an appreciation (when it strengthens) and a depreciation (when it weakens). In this case, the central bank may intervene in the market to manipulate the value of the currency, but it does not change its value by making an announcement. That is why the phrase appreciation of the rupee is used when the rupee gets stronger. Similarly, this explains why we talk about the 1966 devaluation of the rupee. At that time we had a fixed exchange rate. The change in value of the rupee was by official announcement.

What could happen next?

First, the Chinese could allow a slow appreciation, letting the yuan move in a tight band of 0.3 percent per day. However, as everyone expects the yuan to move only one way, we could easily see a few billion dollars flow into China at a very high speed to make a quick buck out of the appreciation. This would make the work of the People's Bank of China, even harder than it was before the revaluation was announced. The bank was buying $20 billion dollars a month over the last few months to counter the pressure on the yuan, and prevent appreciation. Now it will have to buy up even more, in the face of additional speculative flows.

From the viewpoint of Chinese macro policy, buying $20 bilion a month was unsustainable. But at 8.11, they might be forced to buy more, which will be even worse.

Considering the above difficulties, China may decide, as announced in the week following the revaluation, not to allow any further appreciation of the yuan.

But will this help?

China's macroeconomic imbalances are not going to be corrected if the yuan remains where it is today. Also, China's trading partners, especially the US, are not going to be satisfied with a 2.1 percent revaluation. If the currency does not appreciate, the situation is effectively no different from the one that existed before the revaluation. It is difficult to see what China has achieved by moving from a fixed rate at 8.28 yuan/USD to 8.11 yuan/USD.

But it is possible that the Chinese will stick to this rate for a short while. Perhaps the expected impact of a 10 to 20 percent devalution on their exporting SOEs was so high that they simply could not afford a greater revaluation. So, maybe this is the best they could do, and they will stick to it for a while.

Only time will tell which of the two options will be chosen by the Chinese.

How is the rupee dollar rate influenced by the yuan?

One of the arguments that has repeatedly been made by those who are in favour of pegging the rupee to the USD, i.e. allowing very small movements of the rupee-dollar rate, especially in the upward direction, has been that since Chinese exports are cheap, the RBI should also not allow the rupee to appreciate.

Has the situation changed after the revaluation?

Perhaps. But only to a small extent if the yuan remains where it is today. However, if the yuan is allowed to continue to appreciate, the rupee would become more competitive at the current levels. This would create expectations of rupee appreciation in the market. The speculative inflows caused by this expectation would put pressure on the rupee to appreciate.

Should the RBI try to intervene and allow only small movements in the rupee dollar rate, the rupee would become a one way bet. The RBI would face the same problem that the Chinese face today. When any currency is expected to move only one way, it faces speculative capital inflows that hope to cash in on that movement. The intervention would thus be counter productive. If RBI follows the PBC in the moves made by PBC in appreciation, then speculators on the rupee will accompany speculators on the yuan in betting on both currencies together.

The best path for the RBI is to allow full rupee flexibility, atleast until the Chinese yuan drama plays out to the full. Until now the RBI seems to be doing the opposite. One would have hoped that it would have learnt its lesson from the speculative inflows India faced in the period from April 2002 for nearly two years when the rupee was allowed to move in a very small band in the face of pressure to appreciate. To think that administrative procedures will be able to block the thousands of channels that individuals and businesses use to move money in and out of the country - over and underinvoicing of exports and imports, hawala, delays in export proceeds, gifts etc.- is a pipe dream. Nor would a few measures such as blocking Participatory Notes, imposing difficult "Know Your Client" clauses or reducing interest rates on NRI deposits be the solution.

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