The yuan effect

That the yuan will be revalued against its dollar peg is no longer an issue""the issue is when and by what amount. With China's current account surplus surging by 50 per cent last year, and especially considering its huge surplus with the United States, the pressure on China to revalue is very strong.

These pressures are being made not only by the US but by other countries as well. The euro area, in particular, has borne the brunt of a depreciating dollar, while other Asian countries too have seen their competitiveness ebbing away as a result of the unshakeable yuan.

Small wonder that at every meeting at which Chinese leaders are present, talk of a yuan revaluation has been at the forefront. Speculators have been quick to jump on the bandwagon, and billions of dollars have flowed into China to take advantage of a revaluation.

Talk of a yuan revaluation has been affecting other Asian currencies for quite some time, but on Wednesday it spilled over into the tightly controlled Indian market as well, sending the rupee to a five-year high against the dollar.

The argument is that if the yuan is allowed to float, other Asian currencies, including the rupee, will rise in tandem. Whether a stronger yuan will have any impact on the US current account deficit is doubtful, because of the huge price difference between the two countries, but it may certainly boost Indian exports in areas like textiles and auto ancillaries.

That will lead to more dollar inflows. Perhaps more importantly, a stronger yuan may allow the central bank to let the rupee appreciate a bit, thereby dampening inflationary pressures. For all these reasons, the rupee too appreciated against the dollar on rumours of a yuan revaluation on Wednesday.

To be sure, the People's Bank of China was quick to dismiss these reports, but the fact remains that speculation will continue till a revaluation occurs. Nor was it only the foreign exchange market that was affected by the yuan revaluation story""the debt market too rallied on the news.

The logic is that, with a stronger rupee, inflows of foreign funds may pick up, forcing the RBI to intervene to defend the dollar, which would release rupees into the debt markets, thus increasing liquidity.

It would be a mistake, however, to focus solely on the revaluation of the yuan as a factor affecting the rupee. Recent data emanating out of the US seem to indicate that fears of a soft patch in the economy have been exaggerated.

If that is true then the US Federal Reserve will continue with its policy of tightening, and interest rates will continue to go up till the Fed's "neutral" rate of 4 to 5 per cent is achieved. The dollar too has strengthened on the back of a smaller than anticipated US current account deficit. Both these factors will be negative for funds flows to emerging markets, including India.

Further, a deteriorating balance of payments and an overvalued rupee (according to some REER computations) also act as dampeners on the rupee. In short, while a yuan revaluation will be positive for the rupee, it is one of a complex web of factors that affect the currency, and the net impact is far from clear, as is seen from the volatility in markets across the world.