All you wanted to know about yuan revaluation

China's move to revalue the Yuan on July 21, 2005, was hailed as a surprise. But its revaluation by 2.1% was definitely not surprising!

China once again proved its mettle by taking action on its own terms. It pegged the Yuan against a basket of currencies of China's major trading partners but refused to reveal the constituents of the basket.

Finally, the Chinese authorities revealed, almost a month after the revaluation, that the basket consisted of the US Dollar, the Yen, the Korean Won and the Euro.

On Thursday, July 21, 2005, the day Yuan was revalued, it closed at 8.11 Yuans per dollar. On that day, the Chinese officials announced that the Yuan will now be allowed to float against the dollar within a band of plus or minus 0.3% of the previous day's closing.

The band of 0.3% within which the Yuan is allowed to float against the dollar is too narrow and a 2.1% revaluation is just a drop in the ocean given that Yuan is said to be undervalued by as much as 40%.

Beijing made a move which will hardly have an effect on its exports and at the same time has managed to shut up Washington for some time.

Later, a band of 1.5% was announced for non-dollar currencies. On Friday, September 23, 2005, once again this band was widened further to 3% per day for non-dollar currencies. This means that now Yuan is allowed to float within a band of plus or minus 3% of the previous day's closing against non-dollar currencies and 0.3% against the dollar.

The different bands for dollar and non-dollar currencies will prove a difficult act to balance for the People's Bank of China as both these currencies are also trading against each other.

The Chinese pegging of the Yuan has been in the line of fire for a long time now. Yuan was pegged to the US dollar in 1994 at 8.28 Yuans per dollar. This has been a source of grief for most of the industrialised nations (G7 members), particularly the United States (US).

Nearly 10% of the huge current account deficit of the United States, which was a staggering $164.7 billion in the third quarter of last year, was on account of China alone.

People's Bank of China Governor, Zhou Xiaochuan, claims that China needs time to reform its financial sector. But the industrialised nations are becoming more and more desperate as they are getting increasingly aware of the fact that poorer countries are financing the current account deficits of industrialised nations.

The current accounts of all the G7 countries taken together are in a deficit. On the other hand, China had a trade surplus of $31.98 billion in 2004.

The move to revalue Yuan by China was seen as a way to ease the growing tension between the US and China, before the impending visit of the Chinese President Hu Jintao to Washington in September 2005. It is definitely not expected to make any significant improvement to the trade deficits of US with China or the fiscal deficit of US.

Heads I win. . .

Recently, the Hong Kong-based, China National Offshore Oil Corporation (CNOOC), a publicly listed company in which the Chinese government has a 71% stake, made a bid to buy Unocal, America's eighth biggest oil company, for an all cash deal of $18.5 billion.

CNOOC outbid Chevron, the American oil company which made a bid of $17 billion for Unocal. Even though the deal did not go through, this bid to acquire Unocal (and similar bids to acquire other foreign companies) signals that China is now following an aggressive policy of investing overseas to utilise its huge forex reserves.

For the Chinese government such deals make a lot of sense. These deals will help China to reduce the monetary impact of keeping its currency, the Yuan, undervalued. Since the dollars, spend in acquiring the overseas assets need not be exchanged for Yuan, this will lead to a real contraction in money supply.

If the Chinese are able to successfully execute this strategy then even without revaluing the Yuan to a great extent, China can prevent its internal economy from overheating.

This can become a thorn in the neck of Alan Greenspan and Co who have been relying on the consistent purchase of the American Treasuries at low interest rates by China and other Asian nations to finance America's burgeoning fiscal and current account deficit at extremely low interest rates.

This has also helped in keeping the inflation low. China is sitting on top of $700 billion of forex reserves of which $230 billion has been invested in American Government securities.

Now with Chinese companies actually prowling for overseas assets China's investment in American treasuries can go down. This might lead to increased interest rates in America.

So basically, now that the pressure to revalue the Yuan will be taken off China's back for sometime, China can relax and not go for any further revaluations and still be at a comfortable level.

. . . tails you lose

On the other hand, even if China goes for more revaluations of Yuan in the future, being a developing economy with a large and growing manufacturing sector, China's import demand is going to be continuously high in the coming years and the importers are going to benefit from a stronger Yuan.

Also, China is a net oil importing country with demand for oil expected to go up as China progresses, once again a stronger Yuan will benefit China, as the US dollar is the currency in which oil is traded.

The Chinese executives and analysts believe that the Chinese exporters will remain competitive even if the yuan appreciates, say by as much as 25%. It will still not make much difference to the Chinese businesses.

The competitive advantage of the Chinese firms goes much beyond just cheap labor and an undervalued currency. The Chinese firms have mastered the art of building plants and factories at much lower costs than it's possible in the Western countries.

Too early to celebrate

Malaysia has already dropped its peg to the US dollar just after the Chinese announcement and moved to a managed float against a basket of currencies. Those Asian countries which were not letting their currencies appreciate by resorting to sterilisation so that their exports maintain their competitiveness vis-a vis the Chinese, have let their currencies strengthen considerably since the revaluation announcement.

Is this just the beginning? We do not think so. It is the beginning of a very long wait. It may be too early to laud the People's Bank of China's move wholeheartedly. The Bush administration may see the revaluation as a victory, but the real victory will be if China continues to revalue the Yuan at regular intervals to bring it to its intrinsic value.

And this as of now seems too farfetched. It should not be forgotten that China has taken ten long years to make the small change that it did on July 21, 2005. From the comments of the Chinese officials in the past, it was clear that eventually the Yuan would be let free, but when that would be done was the question. And we are no closer to the answer now than we were earlier!

Nupur Hetamsaria is ACCA, Faculty, ICFAI Business School, Hyderabad. Vivek Kaul is a freelance writer.