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The Impact of Yuan Revaluation

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The Impact of Yuan Revaluation - January 16th, 2006

Abstract
China has revaluated its currency in July 2005. It sent a ripple of quest across the world regarding what effect it will have on Chinese economy and financial market. How USA is going to get affected after China has removed the pegging? This paper discusses the effect of "Yuan Revaluation" on China, USA and India.
How theses countries are going to get benefited or losing some of the
advantages that existed before the step of unpegging the currency was taken is discussed on macro level.
The article will discuss the possible outcome of "The Yuan Revaluation" from China, US and India perspective and how China managed a fine balancing act.

The Impact of Yuan Revaluation
On July 21, 2005, China abandoned the 11-year peg of its currency, Yuan, at RMB 8.28 to the dollar. From now on, the Yuan will be linked to a basket of currency (write currency and number of currency), the central parity of Yuan is decided to set at the end of each day. The Yuan central rate was devalued by 2.1% at RMB 8.11 (far lesser than what the actual value should be). The new exchange-rate regime might prove taxing to the Chinese firms but would help to control the over-heated Chinese economy, the burgeoning US trade deficit and asset pricing bubble.

Brief History
The Yuan has been pegged to US dollar since Jan'1994 when China adopted a new managed floating rate regime within narrow band. Under this Chinese Central Bank (the People's Bank of China) unified rate for all authorized foreign transaction at RMB 8.7 per dollar. The rate was flexible to adjust within a narrow band of 0.25% of previous day's reference date. The Yuan began to appreciate in the year '94 and for the first time in May 1995 touched RMB 8.3 per dollar (5% increase) and remained around the same value for next two years finally appreciating to RMB 8.21 per dollar and had been maintained till it was pegged to a basket of currency.

Although the regime was known as market driven managed float, it was de facto pegged to dollar since '94.
Currency Evaluation
The Goal
Under a "float", which China says it wants someday, a currency rises and falls on global markets according to supply and demand. This is the system that applies to many major currencies such as the US Dollar, the Euro and the British Pound.
The Old System
Under a "peg", which China has had since 1995, the currency's value is fixed - in China's case, at 8.28 Yuan per US Dollar.
The New System
Under a "managed float", which China adopted in July' 05, the currency can rise and fall but only within prescribed limits.

The Controversy
The hue and cry for revaluation of Yuan was primarily because of following reasons: -
·In PPP terms, Yuan is substantially under-valued. The Big Mac index assesses Chinese currency as undervalued by 59% in the release of Jun 9, 2005.
·One fourth of the US trade deficit (which was shot up to US$ 600 bn, 5% of US GDP). Given the extravagant life style of Americans, social security proposal, prospect of continued increasing outlays because of rising tension with North Korea, Syria and Iran, the US budget deficit is expected to inflate. Appreciation of Chinese currency is expected to curb this deficit up to some extent, if not completely.
·Given the healthy Balance of Trade, Balance of Payments, FDI, Exchange Reserves, GDP growth in last few years, Yuan has become stronger along with Chinese economy and demand for its currency has also improved.

Advantages & Disadvantages of Yuan Becoming More Valuable
An upward revaluation of the Renminbi would carry its own pros and cons. What is appreciable over here is "How the Chinese government has walked a thin tight rope by managing not to tick off its domestic industry nor its trade partner."

For China
The maximum trade of China is with US (contribute almost 21% to Chinese exports). Changing pegging from one to 11 currencies will have stiff impact on China.

Advantages
Cheaper Imports
China imports technologies, petroleum, metals, machinery and skills from other countries. China is the biggest consumer of many commodities such as aluminum, steel, coal and copper and second largest consumer of oil. With the increasing prices of these commodities, appreciating Yuan will put less pressure.

Overseas Investment and Expansion
With huge forex reserve (US $514 bn in Sept'04), a stronger Yuan and government loosening the control on capital outflow, it will be economically rewarding to invest abroad. On the other hand, Chinese firms may desist from investing abroad if they fear further depreciation may not provide required rate of return. In short run, they prefer to wait before dollar depreciate before making investment.

Control of Inflation
Inflation can act as damper to overheating prices and excess liquidity. Increased income and more confident mindset of Chinese has improved the marginal propensity of consumer, fostering to excess liquidity and made Chinese Central bank's sterilization strategy of issuing bonds less effective.

Reduced Foreign Debt Obligation
The dollar denominated debt obligation would be reduced (in Yuan terms) once Yuan will be revalued (because of depreciation of Dollar vis-*-vis Yuan). As per estimate, the principal of foreign denominated bond will be reduced up to 15%.

Focus on Domestic Economy
Revaluation of Yuan will force Chinese economy to become more productive, in order to counter the disadvantage occurring because of revaluation of currency. Chinese economy is excessive export-oriented which is dangerous (Japan has faced chronic deflation and three recessions in last decade because of its export focus and had left internal demand under-developed). Initially, this step of Yuan revaluation may hurt Chinese economy as prices may rise and take hit on profit margin. In long term, if efficiency is achieved and domestic demand is adjusted, enterprise would be able to generate more wealth.

Disadvantages
Growth can be Stagnated
Purchasing power of US customers will be affected because of Yuan appreciation; hence China will lose 'cost advantage' leading to fall in exports. This will show decreases in output and increased unemployment, which is already a big problem (even though there is boom in export after lifting the quotas).

Impact on FDI
FDI flow may decease drastically as the new investment will become unviable and existing one will no longer be economically beneficial as they used to be. Moreover, there will be increased forex risk associated with it. This could hamper economic growth of China and have considerable impact (as FDI is very high in China because of less stringent norms).

Immature Market
The financial market of China (which is not most robust market) may not be able to handle revaluation. The Shenzhen and Shanghai Exchange were formed in late 90's and even then they were used for funneling the fund in state-owned enterprise.

A sudden appreciation of currency will badly affect many financially unsophisticated and unhedged firms.

Increase in NPAS of Bank
The weak banking system of China has huge NPAs and it is being mobilized and sold to US investors. Increased value of Yuan will reduce its appeal to US investors.

Hot Money & Increase in Volatility
There has been huge capital influx into China recently purely through speculation. Once revaluation is done and investors gain sufficient return, this capital will flow out of country. If it revaluates too slowly, it might be indicator to investors that more appreciation is to come, but if it happens too fast, there would be too many funds at once. Depending upon the rate of revaluation, it may or may not be a threat of fund outflow. Either way high volatility is assured. In case of deliberate pull back of economy, curbing possible gain from non-currency means lead to investors will to remain invested.

What will be the Impact on USA?

Advantages
Control Over Deficit
China alone forms one third of US $600 bn global trade deficit. A revaluation of Yuan would definitely help US control the deficit.

Political Pressure
The political debates in US are heating up over the rising menace of the Chinese dragon. Outsourcing and steady stream of job losses in past years have increased the pressure on the policy makers to act.

Increased Export
With the increasing Yuan, the US export to China would become more affordable to Chinese consumer, and hence, will get a boost.

Disadvantages
Rise in Interest Rate
With dollar becoming weaker, FDI flows in China will decrease leading to decrease in Chinese Central bank investment in US Treasury Bill. The current trend of reverse diversification, where central banks across the globe are widening their investing by divesting in dollars investment and investing in other currencies, as china move towards pegging the RMB to a basket of currencies, there will be a notable impact on Euro. China is world's third largest investor in US Treasury Bill. This revaluation will force Chinese policy maker to sell their holding in US Treasury Bill and buy in Euro and Yen. This will ultimately decrease the demand for federal T-Bill and interest rate will rise. The falling dollar and increasing interest rate will not only hurt US but also impact Asian countries such as Japan, China, India and to an extent Russia as well. Therefore, these countries will also try to play diplomatically and diversifying their investment back stage.

Short-term Inflation
In short run, Chinese products will be available at low price. Given the high spending habits of US consumer, it will definitely increase the inflation atleast in short run.

How India will get affected?

Advantages
Improved Export
As compared to before revaluation of RMB, the Indian products will be cheaper now and India Inc. surely would be able to capitalize on this opportunity.

Outsourcing Advantage
Apart from IT and ITES, India's relatively cheap labour will be now exploited by the US firms. As the Yuan appreciates, the NPV of investment in China will start decreasing, the money might be diverted to India as well.

Disadvantages
Absence of Cheap Chinese Goods
There will be same effect of revaluation to India as I have previously discussed in case of USA.
Regarding to rest of the world, some of the Asian currencies are also expected to see the upward movement. A revaluation may break the monopolistic market that China has held till now over the US export market and open up trade opportunities for the rest of the world.

Conclusion
In July'05, China allowed its currency to appreciate by 2.1% and permitted daily fluctuation of upto 0.3%. This has aroused every one's curiosity as to what effect it will have on economic growth.
Page - 8
Under the pressure, China has diplomatically improved its currency only by 2.1%. In short run, it will matter least as China will not do anything that will increase speculation on currency or increase unemployment. Any serious evaluation of its currency therefore will take longer time.
The Yuan Revaluation will have its advantages and disadvantages. Other countries especially USA will also get affected but the effect in immediate future will be small.
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Re: The Impact of Yuan Revaluation - January 16th, 2006

The following articles are abstracts of newsletter published by the very famous Wharton University.


IS CHINA REALLY GOING TO BE A SUPER POWER IN 2 DECADES ??



Economists and editorial writers often paint China's ascent as one more case of an emerging economy on its way up, preceded by Japan and the Asian "tigers" (South Korea, Singapore, Taiwan, and Hong Kong), and soon to be joined by India. It is anything but: China's rise has more in common with the rise of the United States a century earlier than with the progress of its modern-day predecessors and followers. What we are witnessing is the sustained and dramatic growth of a future world power, with an unmatched breadth of resources, lofty aspirations, strong bargaining position, and the financial and technological wherewithal of an established and business-savvy Diaspora. The impact of a rising China on the countries of the world—both developed and developing—will be enormous, and so will be the need to develop strategies and responses to meet the challenge.
This book is not about China bashing in the tradition of the Japan-bashing media of the 1980s, nor a glowing praise of the "Japan as Number 1" genre. Rather, its aim is to capture the impact that the inevitable ascent of China will have on businesses, employees, and consumers around the world—especially in the United States—and assess what firms and individuals will have to do to remain competitive in the new order. It is the position of this book that the "dislocations" brought about by China's advance are not cyclical and temporary but represent fundamental restructuring of the global business system and a repositioning of its key constituencies. We are about to wake up to a new business environment, with new ground rules for business competition, fresh terms of employment, and novel consumption patterns—one that will redraw the battle lines on the political, economic, and social fronts, and one that will place new challenges at the doorstep of nations, firms, and individuals.
China in the Global Economy

If you adjust for purchasing power differentials, China is already the world's second largest economy. Growing at a faster clip than any other major nation, it is on course to surpass the United States as the world's largest economy within two decades. Some observers discount the Chinese growth numbers as exaggerated, but shaving a point, as they suggest, of a GDP growth rate of seven to eight percent would still leave China with the most rapid growth rate in either the developed or developing world over a sustainable time period. Other observers, relying on proxies such as energy consumption, argue that China's growth rate is actually higher than the official numbers suggest. While the Chinese economy faces some serious roadblocks, such as a crumbling banking system, an inefficient service sector, and a significant disenfranchised element, these obstacles are more likely to slow rather than stop China's economic march.
In many industries, especially those that are labor intensive, China is by now the dominant global player. China-based factories make 70 percent of the world's toys, 60 percent of its bicycles, half its shoes, and one-third of its luggage. In those product categories, it is often impossible to find a non-Chinese product on store shelves. In some other product categories, such as textiles and garments, China's share has been held back by quota and tariff walls that are scheduled to come down following the country's accession to the World Trade Organization (WTO) and the expiration of international trade regimes. China, though, is not content with remaining a low-tech, labor-intensive manufacturer. It is already active in areas where technology plays an important role and labor is not the dominant cost factor. The country builds half of the world's microwave ovens, one-third of its television sets and air conditioners, a quarter of its washers, and one-fifth of its refrigerators; these products represent the fastest-growing segment of its exports. Manufacturers in other countries increasingly rely on Chinese components or subassemblies to stay competitive.
Unlike Japan and Korea, China will not let go of the labor-intensive segment as it moves up the ladder. Instead, it will leverage its dominance in labor-intensive and mid-technology industries to fund a major push into knowledge-intensive areas that will drive the future world economy. It is this combined push that will catapult China into the ranks of leading economic powers, and it is this blend that will pose unprecedented challenges to its global competitors. With an increasingly assertive foreign policy, China is also determined to translate its growing economic muscle into geo-political stature and counterbalance what it sees as America's global hegemony. At the same time, like other nations, China will pull its growing political weight in promoting its economic interests.
Resources and Capabilities

The resources that China brings to the table are all too often discounted and misunderstood. To say that this is a country of 1.3 billion people has become some sort of a cliché, until one considers the implications of this enormous size. Foreign firms salivated for years at the thought of selling a toothbrush to every Chinese, a delusion and a symbol of corporate utopia when it first emerged in the early 1980s, but increasingly a reality, even if confined by region or product category. China is already the largest market for Boeing's commercial aircraft and American machine tool makers, and its automotive market is the most promising in the world. (China is already Volkswagen's biggest foreign market, ahead of the United States.)
The attractiveness of its domestic market provides China with tremendous bargaining power, a trump card that was unavailable to Japan and South Korea before it. The lure of its domestic market enables China to require technology transfer as a condition for foreign investor entry, wringing unprecedented concessions. In the automotive industry, foreign firms such as General Motors agreed to establish research and development centers at a scope never before contemplated in a developing market. Not only did these manufacturers agree to transfer technology that is arguably close to their core capabilities, but they consented to do so in an environment with virtually no protection of intellectual property rights (IPR) and in parallel alliances never before seen: China is the only country in the world where domestic automotive makers maintain equity ventures with competing foreign partners, which makes it possible to learn "best practices" from both and end up with potentially more knowledge than either foreign party. The aim is to produce Chinese multinationals that will hold their own in a global economy and replicate the success of Toyota, Sony, and Samsung, but in a shorter time frame.
China's size also means a vast pool of human resources. The reservoir includes not only an unlimited supply of menial laborers, but also a large and growing number of engineers, scientists, and skilled technicians, many of whom are employed in government-funded research and development centers or in the increasingly prominent technological centers established by foreign multinationals. The coexistence of cheap labor with increasingly abundant skilled personnel defies common assumptions on national competitiveness as a case of "either or" and underlies China's strategy of sustaining its dominance in labor-intensive industries even as it enters technology-intensive realms.
China's scope and pace of modernization of its own educational system is much greater than that of earlier contenders. Even today, Japan's educational system remains largely insular to foreign influences as well as to change in general, which is something the Japanese acknowledge as a serious obstacle to economic advancement and growth in a knowledge economy. Korean universities, while more open than their Japanese counterparts, have only recently started to actively recruit overseas faculty, although they have been recruiting Korean nationals educated abroad for years. Chinese institutions of higher education are showing more openness, and at least the elite institutions are displaying not only readiness but also enthusiasm for adjusting curriculum and making other changes. China's top universities are moving aggressively to upgrade their infrastructure and skill sets, establishing alliances with Western institutions and companies and actively courting foreign-trained faculty.
In addition to boosting its own educational system, China is counting on an eventual influx of Chinese students returning from abroad. Chinese students are now the largest contingent of foreign students in the United States. According to the Institute of International Education, more than 64,000 students from mainland China studied in the United States in 2002–2003. In the same year, the U.S. also hosted more than 8,000 students from Hong Kong and more than 28,000 from Taiwan, for a total of over 100,000. Chinese students also study in Europe, Australia, and Japan, among other host countries. The Chinese government has been accelerating its efforts to entice the best and brightest of this crop to return, offering "overseas terms" and joint appointments to the most promising prospects. Even without formal incentives, many students as well as practicing scientists and executives are lured back by the wealth of economic opportunities offered by a fast growing economy. These returnees are bringing with them not only academic knowledge, but also something else the Chinese sorely need: application know-how and business-related expertise.
Another important source of technological, scientific, and managerial knowledge resides in the economies of Taiwan and Hong Kong. Pushed in part by Chinese low-end producers breathing at their necks, both territories—not to mention Singapore—have been busy upgrading their educational systems over the past two decades. Hong Kong now boasts eight universities, up from three in the late 1970s. These universities, some of which are world class, play a key role in upgrading China's human resource infrastructure; increasingly, they are host to mainland students, and many of their local graduates end up working directly or indirectly with mainland enterprises.
That said, China has a long way to go before it can overcome key weaknesses, such as lacking a developed service sector to support its manufacturing base and to which to channel some of its superfluous personnel, a banking sector not far from default, and a limited ability to generate technological innovation. Judging from past experience, however, there is every reason to believe that China will be able to overcome these problems, emerging even stronger from the process. A key strength is that China is not alone; rather, it's the hub of a cluster of complementary and increasingly integrated economies that is Greater China.
The Synergies of Greater China

In a cultural, economic, and geo-political sense, China consists not only of the People's Republic, but also of Hong Kong, an entrepreneurial center which, from 1997, has been a Special Administrative Region of China with its own trade and foreign investment jurisdiction; Taiwan, a technologically advanced island, its contentious political status notwithstanding (China sees Taiwan as a renegade province), which is increasingly integrated into the Chinese economy; perhaps even predominantly Chinese Singapore, a center for high technology manufacturing and a base for many multinational enterprises; and a vast Chinese Diaspora that occupies the ranks of much of the business elites of Southeast Asia and is active in business circles around the globe. An example is Hong Kong-based Hutchison Whampoa, a diversified conglomerate with close to $20 billion in revenue and operations in more than 40 countries.
Put these different parts of the Chinese puzzle together, and you find unequaled potential: a human resource pool that is not only the largest in the world but also includes a large number of scientists, engineers, and seasoned executives; an advanced and rapidly progressing technological infrastructure, and a leading industry position in many emerging technologies (Taiwan is the world's largest producer of notebook computers); vast capital (together, the economies of China, Taiwan, Hong Kong, and Singapore have three-quarter trillion dollars in foreign reserves); a dominant trade position (Hong Kong's container port is among the busiest and most advanced in the world); major bases and Asian regional headquarters for multinational enterprises (Shanghai, Hong Kong, and Singapore); and global business savvy (the Chinese Diaspora).
Increasingly integrated (Singapore somewhat less so) and dependent on their mainland China business, those economies possess complementary and synergetic attributes of capital, skill, knowledge, human resources, and market savvy that can deliver development on a magnitude and at a pace never before seen in a developing economy. At almost $1.4 trillion, Greater China's (the PRC, Hong Kong, Taiwan, and Singapore) merchandise trade trails only that of the European Union and the U.S. and is almost double the Japanese volume. In an increasingly global economy, this volume forms the basis for tremendous bargaining power as other trading nations weigh their responses to trade and economic issues in the context of broader flows and their own exports. Greater China is rapidly becoming the hub for an even larger and rapidly growing Asian economy: Mainland China is already South Korea's biggest export market, while Greater China is the biggest market for virtually all other Asian nations


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Re: The Impact of Yuan Revaluation - January 16th, 2006

China Takes on the World

China's pressure on U.S. markets will only grow stronger. Companies that until now hesitated about shifting production to the country due to union agreements or for fear of a consumer backlash now realize they may have no choice if they wish to stay in business. Firms initially protected from Chinese competition by high transportation costs find themselves on the firing line as logistic costs decline and as productivity rises on the Chinese side. Others are following their industrial customers who have moved to China and need their suppliers and service providers to be close by. Even companies supplying the U.S. defense establishment now realize they may have little choice, although they try hard to keep their core operations at home. Consultants and other service personnel follow to provide support for those operations and discover that China, like some other low-cost nations, is a good base from which to support overseas operations.
"The great and well-known amount of imports of the productions of China into the United States," wrote Daniel Webster, Secretary of State in the John Tyler administration, in 1843, "are not likely to be diminished."4 Eventually, of course, it did. But while the quote serves as a reminder of the limits of forecasting, indications are that for now, the tide of Chinese exports will only grow. It will also not stop at America's shores. For now, the EU runs a merchandise trade deficit of about $45 billion with China, but imports from China represent merely 1.8 percent of its total imports (EU countries included), and half its volume of Japanese imports (2002 figures). Once Chinese exports grow—and especially when they begin to challenge Europe's strategic and politically influential industries such as motor vehicles—the sentiment may change there, too, although it will remain subdued as long as European exports remain strong and as long as the more influential EU nations, such as Germany, have a relatively small deficit. Japan, whose worries about China are also geo-political, is especially vulnerable to China's ascent, because its competitive advantage lies in manufacturing, its economy has stagnated for over a decade, and its governance and corporate practices have slowed its adjustment to a changing global economy. Like the U.S., Japan's exports to China are about half its import level, and as in the case of the U.S., many of its imports from China are by Japanese firms that now manufacture there. However, unlike in the U.S. case, China is the only major economy with which Japan runs a significant trade deficit (Japan's exports to the U.S. are about twice its import level), which cushions the impact. And, being much more dependent on trade than both the U.S. and China, Japan can ill-afford to challenge the free trade system.
While the industrialized countries take (artificial) solace from the belief that China only threatens the labor-intensive part of their economies, developing nations do not have that luxury. Developing countries find themselves trailing in the contest for developed country investment dollars and watch with trepidation as foreign investors uproot operations in their markets and shift them to China. The Chinese edge in terms of cheaper labor cost, a modern infrastructure, and the benefits of scale and agglomeration is now often sufficient to erase the proximity advantage of countries like Mexico, who have been counting on the combination of geography and NAFTA as a sort of insurance policy in the U.S. market. They are now finding out that payout is not guaranteed.
For emerging and developing economies in Asia, the Chinese impact is more ambivalent. While Asian countries continue to lose foreign investment to their powerful neighbor, the country is becoming an engine of growth for the entire region and a complement if not a substitute to developed country markets. (For instance, China has now replaced the United States as South Korea's largest foreign market.) With the notable exception of Japan, most Asian economies are running a trade surplus with China, and so do not see Chinese imports as an immediate concern. Nevertheless, China is considered a possible worry among Asian nations, some of which are only one step ahead on the development ladder and hence vulnerable to Chinese economic progress. In addition, there is considerable unease about the influence of the Chinese business elite, especially in the Muslim nations of Indonesia and Malaysia, as well as suspicion that the Chinese minority will benefit from China's rise while the ethnic masses will suffer as low-paying jobs move to China. Finally, Asian nations are concerned with changing geo-politics: Post World War II Japan was suspected because of its prewar and war record, but it did not have the military might and was a close U.S. ally. China, while historically nonexpansionist, is still a Communist nation, with the largest standing army in the world and strong geo-political aspirations.
In the heels of the China impact will come numerous aftershocks that will ripple their way throughout the world: rising prices for the energy and commodities that the burgeoning Chinese economy is devouring, severe "dislocations" for employees and their communities in regions and industries unable to compete or restructure, waves of immigrants pushed out of Central America and other regions by the devastation of the labor-intensive operations they have come to rely upon, and, down the road, a new geo-political order in which China takes one of the leadership roles.


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