The last two weeks have been eventful. The growth of the Maoist insurgency, the re-establishment of the National Advisory Council and the visit of the US treasury secretary—leading to speculations on the dollar-yuan issues—have dominated news. People seem to have now accepted that the yuan is undervalued against the dollar; China’s central bank is likely to announce an appreciation of the currency together with a wider band for the currency to trade in. It has been argued in India (including by this paper), that a revaluation of the yuan would make Indian exports more competitive in dollar-denominated areas. Yet, even in the US, there appear to be contradictory views, questioning whether a sharp yuan appreciation would be beneficial to the US, or even to other economies.
An appreciation in the yuan against the dollar would make imports into the US dearer, and is expected to help rebalance the trade between the two countries. Some commentators feel that this would happen in India as well, helping bridge our huge trade deficit, of close to $23 billion annually, with China.
But there are two arguments against this view. First, China has been preparing for this eventuality since July 2008. Between 2005 and 2008, it allowed its currency to strengthen, but this led to large “hot money”—short-term capital flows— that attempted to take advantage of the arbitrage opportunities against the dollar. China went back to a fixed exchange regime in July 2008 and has since pursued a more long-term policy. It is strengthening infrastructure in terms of fast expressways and fast trains, to reduce transportation costs. It is outsourcing low-value production to South-East Asian countries, including Vietnam and Myanmar, and more recently, to Bangladesh. Both wage increases and the increase in costs of funds are pushing Chinese firms into greater efficiencies in using capital. These structural adjustments will help China emerge as a more efficient producer of value-added goods, which could still be globally competitive.
Second, imports to India are fairly inelastic, meaning a price rise won’t force down volumes. Telecom equipment, power station generators, capital equipment and white goods constitute a substantial proportion of imports, and a higher yuan could contribute to inflationary pressures instead of a reduction in imports. In any case, the trade imbalance cannot be solved by the appreciation in the yuan alone, unless it doubles in value. Further, if any revaluation drives down the Chinese purchase of US treasury bonds, the US would be hard put to fund its fiscal deficit, except through monetization—a clear danger for India.
Of equal interest to India is the yuan-denominated trade that is emerging, especially in the last one year. Several months ago, in these columns, I had written of China’s strategy of persuading countries to accept the yuan as the currency of trade. Now, nearly 20 countries—including Indonesia, Malaysia and Myanmar—have accepted. These are also countries that have a trade surplus with China, and so it helps China to keep the surpluses in its own currency. Some African countries that have entered into this trade are being compensated through infrastructure projects and aid. Finally, China paid its latest contribution to the International Monetary Fund (IMF) in its own currency, IMF making an exception for this purpose.
These developments are of particular interest to us. Two possible approaches come to mind. One, if we consider a greater integration of South Asian trade, there is an opportunity to use the Indian rupee as a denominator—in Bangladesh, Nepal and Sri Lanka, it is already a de facto exchangeable currency. We can conceive of a number of countries with which this could be tried. Two, with countries that have accepted yuan trade, India has an opportunity to push its own exports, but denominated in dollars, offering the attraction of this more widely convertible currency.
More broadly, these developments call for a major strategy shift in trade and economic policies. In Asia, it is likely that China, Japan and South Korea may comprise a trading bloc in the future. It is also possible that this trading bloc’s influence may extend to South-East Asia as well. Again, there are opportunities. There are free trade agreement (FTA) negotiations in progress with the Association of Southeast Asian Nations, and for deepening the current FTA with Thailand. There is an opportunity to enter into a tariff-free zone agreement with Bangladesh, and to deepen relations with Sri Lanka. It is time to engage with Myanmar and, indeed, with the southern part of China. The concept of a Bangladesh-India-China-Myanmar bloc, recently mooted by Bangladesh, could be a good step. We need to leverage our advantages to handle our trade deficits.
Perhaps this involves a change in mindset. The strong argument currently for India’s growth focuses on internal demand. Opening up foreign direct investment would encourage foreign capital to generate production within the country to satisfy this demand. This would help balance the trade gap through the capital account, and also contribute to capital infusion. So it is not surprising that the government is thinking in this language. But there is another language it can think in, that can balance the trade gap through the trade account itself.
S. Narayan, a senior research fellow at the Institute of South Asian Studies, Singapore, is a former finance secretary. We welcome your comments at firstname.lastname@example.org