Subir Gokarn: Appreciating the yuan

India is not well-positioned to take full advantage of the yuan revaluation.

On July 21, China announced a change in its exchange rate policy. It moved from its previous "hard peg" of 8.28 yuan per US dollar to a new value of 8.11, representing an appreciation of about 2.1 per cent.

The magnitude of the revaluation is relatively insignificant, given widespread perceptions about the extent of the undervaluation of the yuan.

The US threat to impose punitive tariffs of 27.5 per cent on imports from China reflects its assessment of just how much below its market value the yuan was.

Given this, it would be reasonable to expect that this step is really the first in a series that will gradually take the currency closer to a rate that reflects the fundamental drivers of forex flows to and from of the Chinese economy.

If so, it could well be the trigger for the global economy to move to a new equilibrium. What are the likely characteristics of this new equilibrium? And, what are its implications for India?

To simplify things a bit, the current global equilibrium can be described as a "US consuming-Asia producing" one.

The US trade deficit is setting records, while, on the other side of the equation, the Asian economies are accumulating forex reserves to unprecedented levels.

They are doing this essentially to prevent the appreciation of their currencies vis-à-vis the dollar, which would have been inevitable if the Asian currencies were really floating.

Rising trade deficits in the US have typically provoked protectionist responses, so the threat of punitive action against China, with whom the US's bilateral trade deficit is by far the largest amongst all its trading partners, isn't surprising.

The reality, however, is that any shift in production away from China as a result of either punitive tariffs or significant yuan appreciation, is hardly likely to be in favour of the US.

It is most probably going to go to the other Asian economies, whose competitiveness vis-à-vis China was most significantly impacted by exchange rates.

Further, given the fact that goods produced in China occupy an increasing share of the average American household's budget, yuan appreciation can actually contribute to higher consumer prices in the US.

But then, protectionism is rarely driven by the interests of the average household.

Virtually all the Asian currencies (including the rupee) are undervalued to some extent, but almost certainly, not to the same degree as the yuan.

If indeed, the yuan continues to appreciate, all these countries can afford to move away from a managed exchange policy and towards a genuine float while still gaining in competitiveness relative to China.

This would mean that US imports from all Asia countries would become more expensive, leading to some shrinkage in volumes.

However, within the smaller volumes, there would be some substitution of Chinese products by those from other Asian countries.

From this perspective, a slowdown in Chinese industrial production and, consequently, GDP growth, is inevitable. To an extent, this outcome is consistent with the Chinese government's stated objective of "cooling down" the economy from its 9-9.5 per cent growth trajectory to a more sustainable and less threatening 7 per cent path.

However, when it was announced, the cooling down strategy relied heavily on compressing domestic demand, for example, by reducing public investment.

Exports were not projected as an instrument of the strategy.

This, to my mind, was because of two significant perceived risks. One, a rather fragile financial system, dealing with high levels of non-performing assets and vulnerable to a disruption of cash inflows, was dependent on export earnings to keep it going.

Two, exporting establishments work within relatively flexible labour regulations, so a slowdown in exports could well precipitate large-scale unemployment.

The decision to revalue the yuan could, conceivably, be a result of a re-assessment of those risks, but, to my mind, this is highly unlikely.

The risks remain high and real and, having conceded to international pressure to change its currency stance, the Chinese government will take every step to minimise the inevitable impact on both the financial sector and labour markets.

Whether it will succeed or not is the big question, and one that is rather difficult to answer at this point. If the Chinese succeed, there will be a gradual adjustment to a "US consuming less-Asia producing less" equilibrium, but in a scenario in which both currencies and goods are far more rational, i.e. driven by fundamentals and, therefore, far more sustainable. If they do not, the possibilities of upheaval in China loom.

Discounting the upheaval scenario for now, Indian manufacturing potentially stands to gain from the relocation of production from China to the rest of Asia.

However, it is pretty obvious that there can be only a rather small gain in India from exchange rate re-alignments.

However large the opportunity may be, it can only be exploited when several pressing micro-level constraints are removed.

Even when it's not raining, Mumbai is no Shanghai. In short, China's loss is not very likely to be India's gain for some time to come, if at all.

There are concerns on the services front, though. Rupee appreciation will make offshoring to India less attractive; margins will suffer if volumes are to be maintained.

There aren't too many locations that seriously compete with India in this broad area, but to the extent that relocation out of India does happen, we will feel an impact.

But, here again, one should emphasise the fact that true competitiveness does not come on the back of a distorted exchange rate.

Strong export performance with a rationally priced currency is a much more credible benchmark of competitiveness.

That is the challenge that Indian service exporters have to meet.

To sum up, the exchange rate re-alignment emerging after China's revaluation last month is likely to induce a reduction in US demand for Asian goods and services, but, for countries other than China, this may be offset by a gain in their individual market shares.

India is, unfortunately, not well-positioned to take full advantage of this opportunity and, further, faces some risks to its service exports because of rupee appreciation.

The transitions should be manageable for the governments of most of the countries involved. The big question mark, however, is China's ability to deal with potentially heavy domestic turbulence. We do not quite have an appreciation of that.

The author is chief economist, Crisil. The views here are personal