Gaining Currency

Indian Express, 24 June 2010

China claims it has moved to a more flexible exchange rate. The People's Bank of China announced its intention of moving towards a more flexible exchange rate regime by allowing the yuan to move within a band against a basket of currencies of its major trading partners. This week, the yuan has appreciated, sending a signal that China is serious about the announced change. The change in policy has come after mounting pressure from the US. It comes just before the G20 Toronto weekend meeting. The move will not only reduce the political pressure on China, it will take away the G7's bogeyman for the financial crisis. The G20 meet will now have to focus on internal issues of fiscal stimulus, its withdrawl and public debt instead of the Chinese exchange rate regime.

India, which moved to a much more flexible exchange rate regime in 2007, has been looking good in this story. Now, if China does allow a significant appreciation, India also benefits from greater export competitiveness, the political pressure to peg the rupee reduces and the RBI can focus on controlling inflation.

While the Chinese revaluation may have come after pressure from the US there are domestic reasons why it is in Chinese interest to do so. The growth of the internal market in China is constrained by, one, the low distribution of profit income to households, as State Owned Enterprises do not distribute dividends, and, two, the low growth of real wages. The Chinese growth model depends largely on the reinvestment of profits, giving investment as an engine of growth, and high growth in exports, providing the second, and most important, engine of growth, for the economy. The government has supported exports with good infrastructure and labour laws, as well as subsidised them through cheap credit, inputs and through the exchange rate regime. By prevening yuan appreciation Chinese exports have remained cheap. This constituted a subsidy to exporters and domestic consumers paid more for all importables, than they would have done had the yuan been allowed to be market determined.

For India, this has led to a discussion on two questions. One is about the desirability of following such a growth strategy. The other is about the ability of the Indian government to do what it takes to implement this strategy. If you focus only on the high growth rate this strategy yielded for China, the strategy looks very attractive. Many commentators who felt that India could grow much faster, if, like China, we also kept our exports cheap, felt that we were losing out on growth compared to our neighbours. However, if you focus on the growth in consumption by households in the country, the strategy looks pretty flawed. With households being paid low wages, and not being paid a serious share of profits, the growth in household consumer demand fell behind GDP growth and domestic consumption fell from 60 percent to barely 40 percent of GDP. (In India, domestic consumption is nearly 70 percent of GDP). Not only does the Chinese path not appear desirable from a development perspective, it does not appear to be something the Indian government could have achieved in the Indian social and political setting.

The repression of consumption accompanying undervaluation of the exchange rate is implemented though a number of steps. The central bank intervenes in the foreign exchange market. This leads to an increase in the monetary base, and so the central bank then attempts to sterilise its intervention. This is done by selling government bonds. The banking system holds the bulk of government bonds in India and China. If banks don't want to hold these bonds, the central bank steps in to force them to do so. This "financial repression" under which banks are forced to hold low interest bearing government bonds, instead of lending to profitable businesses, was done through "targeted issues" by the People's Bank of China who would identify the banks that had witnessed the maximum growth in bank deposits as those who had to purchase these bonds. The interest rate on bank deposits was kept low so that banks don't make losses due to a large difference between the rates at which they borrow and the rates at which they lend.

In the coming days if China allows a significant appreciation of the yuan, it will be for domestic reasons. An important reason could be the rise in domestic inflation in China. Preventing appreciation is inflationary. First, because you would have got cheaper tradables if you had allowed it, and second, because when you buy dollars you pay for it with local currency thus pushing up the domestic monetary base. Life for the central bank is much easier if the currency appreciates. It is able to lower inflation without having to raise interest rates or tighten credit. If the economy is overheating, appreciation helps by reducing export demand, and thus contracting aggregate demand, without hurting all domestic firms and households directly through interest rates as would happen when the central bank tightens monetary policy.

It remains to be seen how far the Chinese will go in allowing yuan flexibility. If the PBoC allows slow appreciation of the yuan, it may end up making the yuan a one way bet and attracting greater inflows. It is aware of this and has indicated a two way movement of the yuan. But how much the yuan appreciates will depend on the capacity of the Chinese economy to absorb the domestic rebalancing that it involves.

India and Brazil have supported the US stand for a more flexible yuan with the view that their exports will become more competitive. But even more than competitive exports, India's biggest advantage from a more flexible Chinese exchange rate regime and an appreciating yuan will be the reduced pressure on RBI for fixing the exchange rate and preventing appreciation from old fashioned economists who advocate undervaluation of the exchange rate as a development strategy. Fortunately, the political difficulties associated with inflation have already pushed India away from going too far down that path. Financial repression of the kind that would have been required for following China would have been impossible for India.

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