Monday, December 31, 2007

The Chinese currency (appreciation) issue

On July 21 2005, China announced that its currency (renminbi/yuan) will no longer be pegged to the US dollar. The exchange rate on that day was 8.11 yuan to a dollar. On Dec 31 2007, the exchange rate was 7.3 yuan to a dollar. Thus, the yuan appreciated about 11% in two and a half years. The yuan rose about 1% just this week alone.

But the United States and other trading partners are still pushing for a faster rise, saying a weak yuan is contributing to China's bulging trade surplus by making Chinese exports cheaper and more competitive.

The strong yuan causes potential problems for the Chinese exporters – since it will cost more for the (US/external) importers. However, a strong yuan (by letting in more imports at a cheaper price) keeps down inflation. However, the Consumer Price Index (CPI) was about 7% higher than last year. Thus the rising inflation makes it much easier for the Chinese government to accept a stronger yuan.

However, the Chinese exporters do not like the strong yuan. Local politicians are also concerned about social issues if the exporters start laying off workers due to hit on margins.

Meanwhile China’s central bank governor Zhou Xiaochuan has stated that he will implement a tight monetary policy in 2008 using a range of tools to keep a check on liquidity. The central bank has increased interest rate 6 times in 2007 to check excess liquidity and inflation.

It will be interesting to see the Chinese dance on holding/appreciation of the yuan. They will do well to avoid the case of “Dutch disease”. The term “Dutch disease” was coined in 1977 by the Economist and it refers to episodes where large inflows of foreign exchange—usually as a result of the discovery of natural resources or massive foreign investment—leads to appreciation of the currency, undermining a country's traditional export industries. ("Dutch disease" originally referred to the adverse impact of the discovery of natural-gas deposits in the Netherlands on that country's manufacturing exports).

India is also in a similar situation with respect to the appreciation of its currency (Rupee). A report released by Goldman Sachs states that the appreciation in rupee will continue to put a downward pressure on inflation, which is forecast to stay around 4.4 per cent in 2008. Let’s see how the 2 countries deal with the currency issue (appreciation) in 2008.

No comments: