War of Words: Yuan vs USD.

The financial world in the last three to four weeks has been a roller coaster ride. The PIIGS trouble dominated the news initially which gave way to much of the focus on Greece. It was almost a nail-biting thriller on what the fate of Greece would be. Would it be bailed out by Germany (and hence Eurozone) or would be punished for its profligate ways. For now, it seems Greece has been able to get out of this mess, but not without considerable pain by the way of benefit cuts, wage cuts and rise in taxes. It remains to be seen whether these so called austerity measures would be enough to bring it out of this fiscal debacle. However, late last week and through this weekend, most of the focus has been on China and its currency manipulation.

First up, Obama railed against China's currency manipulation which China immediately rebuffed. From Bloomberg

“I don’t think the renminbi is undervalued,” Wen said yesterday at a press conference in Beijing marking the end of China’s annual parliamentary meetings, using another term for the yuan. “We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency.”

Then NYTIMES had this article on how China is taking advantage of the rules to keep its currency pegged to the dollar, artificially keeping it low. From NYTIMES:

Seeking to maintain its export dominance, China is engaged in a two-pronged effort: fighting protectionism among its trade partners and holding down the value of its currency.
[...]
China buys dollars and other foreign currencies — worth several hundred billion dollars a year — by selling more of its own currency, which then depresses its value. That intervention helped Chinese exports to surge 46 percent in February compared with a year earlier.

Paul Krugman in his column on monday calls the US to start taking action on China on this issue. He also says that China, with its policies is causing the overall global growth rate slowdown by as much as 1.5%. This issue, if it becomes an all out trade war between the US and China, would have huge ramifications across the globe. How would this affect India, Rupee's exchange rate, our industries and hence our economy.

If China starts dumping dollars (i don't think they would do this, since its like taking all your money and dropping them in the river), then USD would immediately start losing it value. This would mean even our foreign exchange reserves would start losing their value. (Remember this is the most unlikely scenario). The moment USD starts losing its value our IT industry starts losing its edge, which means that a lot of outsourced jobs would go back to the US (if these jobs are still needed, since even the US would be hurt in the short term with such devaluation of dollars). The same could be said about the manufacturing industry. When USD is cheap, it becomes cheaper to manufacture in US itself. So, China is extremely unlikely to do this.

China cannot go on doing what it is doing now which is to keep buying USD to keep Yuan from appreciating. Given the recession and the unpopularity of Obama's administration for the way it handled Wall Street bailouts and Healthcare Reform, this issue would be a godsend to them. Pointing a finger at a foreign country for all the troubles at home is the easiest thing for any politician to do to get the population rally behind him. Since China is infact manipulating its currency and hence is partly responsible for job loss in the US, it becomes all the more easier. This would make it easier for the US to impose new tariffs and make imports from China costlier, thereby undermining Chinese edge. Furthermore, it would only aggravate the relationship between the two countries. So, China is unlikely to continue to do what it is doing now.

The most likely thing would be to have a war of words, both Obama and the communists playing to their domestic audience, and then China would let a controlled appreciation of Yuan by a small percentage. The current view is that Yuan is undervalued by around 20%. So, i think China is giving such a belligerent response only as a bargaining tactic. It would let Yuan appreciate by a few Percentage points so as to placate world opinion, whilst keeping its manufacturing advantage to itself.

But it would interesting to see how these two countries play out this issue in the next fews.

We sure are living in interesting times.