The yuan versus the rupee

April 4, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

China has been under strong pressure from the US to revalue the yuan because in the US balance of trade deficit, China has the lion’s share.

More recently, the emerging market economies have also raised their voice having encountered almost a similar problem. Last week the RBI brought out a Working Paper (WP) which offers a quantitative assessment of China’s tied exchange rate.

From 14th largest exporter in 1990 China became the largest exporter in 2010. This was mainly because the currency was manipulated to sharpen China’s competitive edge. To keep the yuan tied to the dollar China had to buy $1 billion a day and stack it in its foreign exchange reserves.

India’s two-way trade with China, even by 2001-02 was small, less than $3 billion. In the next eight years, it jumped to over $42 billion, with adverse balance against India at $19 billion. India exported iron ore, other ores and metals, raw cotton, chemicals, gems and jewellery which constituted nearly 60% of total exports to China. The bulk imprints were electronic goods and machinery.

Trade expansion was partly due to GDP growth. The manipulated exchange rate also had its impact though the rupee depreciated against the yuan. In 2001-02 the yuan exchanged for Rs.5.5; now the yuan is up at Rs. 6.5 or by 18%. What is relevant, India’s exports responded much less to cheaper rupee than imports.

The rupee depreciation did not work for two reasons. First, the Chinese industry is heavily subsidized. Even losses of public sector enterprises are made up from the Government budget. Second, the unit cost of labour in China has declined 20 to 80% because wages have lagged behind productivity; in India, wages have outpaced productivity by 10 to 100%. The currency advantage vis-à-vis India was nullified by cost advantage to domestic enterprises In China.

The currency advantage also depends on the elasticity of demand for exports and imports. The RBI WP has estimated that the long term elasticity in respect of India’s exports to China is 2.38 and that of imports from China 2.86. The higher import elasticity meant that imports would rise faster than exports. Therefore if yuan is revalued imports will decline more than exports and shrink the trade deficit.

But Premier Wen Jiabao has other ideas. Appreciation of yuan, he said, must be gradual because it affects jobs and raises pressure on enterprises. In the last ten years yuan has appreciated against the dollar by 18%. The reform aimed to adapt the managed float will be based on a basket of currencies instead of the dollar. Even the gradual adjustment of exchange rate will not increase exports to China because the GDP growth is scheduled to be lowered to 7% in the 12th Five Year Plan (2011-15) against the double digit growth earlier.

The chances of correcting India’s trade deficit with China through currency adjustment are slim. Possibly, as the RBI WP recommends diversification of imports may be a practical way.

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