The Chinese Government has, early this week, devalued its currency by 1-2%. This has caused surprise and shock in world capital and stock markets. The extent of devaluation looks minimal but its effect is going to be high on many countries especially India. Almost all currencies have weakened against the dollar and our own rupee has touched 66 to the dollar, a fall of about three rupees in as many days.

Why have the Chinese devalued their currency, the yuan?  In fact, looking at the large foreign exchange reserves that China holds, the yuan should appreciate and not depreciate against the dollar. China holds more than $5000 billion  in foreign exchange reserves the largest outside USA.

China has adopted the fixed rate of exchange for its currency against the dollar since the 1990's at  $1=6.2 yuan app. This has resulted in an unfair advantage to its products in the export markets. China has over the years emerged as the largest exporter of goods in the world. It exports nearly $2000 billion worth of products annually. Compare it with Indian exports of around $320 billion annually. USA at $1500 billions or so is the second largest exporter in the world.

With ever increasing reserves of dollars the availability of it should have made it cheaper to acquire it in local Chinese markets. Thus, if yuan was allowed to float freely against the dollar, perhaps today the rate of exchange would have  been around two yuan to a dollar. This would have made Chinese products three times costlier in the world markets today and it would not have become the largest exporter. Such fixed exchange rate, has also impacted exports of many other countries including India. Our rupee is allowed to freely float against the dollar and demand supply position determines its rate every hour of the day.

The Chinese central bank would buy the increased flow of dollars at the fixed rate and thus more yuan would flood the Chinese economy. This excess would be mopped up by the bank through long term bonds and increased capital expenditure to build high cost infrastructure and other projects. This explains to a large extent,  why the Chinese were in a great hurry to modernize their country as otherwise the economic pressures would make its ballooning economy burst.

With an unfair price advantage giving its producers a huge share of the world export markets, Chinese producers would produce in huge volumes and went on expanding their production capacities. The world wide suppliers of raw materials, commodities and many other raw products were happy to feed the hungry Chinese manufacturing giants. The fixed foreign exchange policy ensured that Chinese goods would be priced the lowest and exports would keep rising.

However the bubble was increasing and many an economist predicted that Chinese economy was weak although it looked strong. As is known the American and many European countries and Japan are going through a recessionary phase since some years. The demand in these countries is almost static. This is an important reason why Indian exports are almost static in the band of $315 to $325 billion since last 3 to 4 years. However the Chinese exports reacted late because they export lot of goods costing around $10 and less into developed countries and these continue to be in demand like toys, household items, electrical fittings, sanitary items etc. It is the  over production in capital items like metals, chemicals, plastics that the Chinese are now finding difficult to export because of low export demand and huge inventories due to excess production. Blocked capital has to be unlocked.

So the  Chinese have resorted to what countries like India have been doing since long, devalue its currency to make its products cheaper in the international markets. This way they want to gain better competitiveness  for their products. But this also shows a weakness in their economy. When the yuan should have appreciated, in view of the huge availability of dollar reserves, it is being artificially being devalued. Is this a sustainable policy, only time will tell.

But its repercussions for India are both good and bad, Good because many foreign investors can now be expected to look towards India for manufacturing to take advantage of our low labour costs and the fact that we are still an emerging economy. For mass produced or assembled items India also gives a stability in form of a huge local market, which acts as a shock absorber in fluctuating international market conditions especially if exports go slow. The Chinese economy is nearly 50% export oriented and it is only now that the Chinese are trying to develop local markets. To improve the purchasing power of Chinese their wages have to be increased and this will adversely  impact the low prices of its exports.

The bad news is that our import bill will go up, widening the trade deficit, which currently is to the tune of $175 billions approx.  Our trade with China is heavily in favour of China. We export around $15 billion versus import of $45 billion from China. Due to price advantage and rupee devaluation the import bill will rise in favour of higher imports from China. The competitive devaluation of the rupee will make our imports more costlier.

China is a single party, no opposition party state. What the few top Communist party officials think and decide is final. It suited the American industry many years back, when they transferred their labour intensive goods manufacturing to China and liked the speed with which the Chinese government opened its doors to facilitate them even violating many human rights of its own citizens, One of the high cost the Chinese have had to pay was the continued low wages in spite of earning huge amounts of dollars. The state is the major owner of industries and thus the party bosses and officials got large sums to use in projects of their liking. Their is reported to be over supply of almost everything in China and lot if it is lying unsold from houses to industrial products. Huge sums of money are tied up and Chinese banks are in danger of not being financially viable.

Therefore the step of devaluing its currency is a bold one and one has to wait and watch how other countries respond to it. Protection of local markets is now important to stop China dumping its products to other countries and causing injury to local manufacturers. Already the Indian steel industry is facing the brunt and first quarter losses have been reported by leading Indian producers. The government is increasing import duties and may have to resort to anti dumping duties.

China is capable of throwing up more surprises to save its economy which is built to a very large extent on an artificial fixed foreign exchange rate steadily held from 1994 till the beginning of this week. If the Chinese economy falters it will adversely affect global economy and recovery will take a long time.