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Journalism of Courage
After five months of negotiations, the US has signed an agreement with China under which certain Chinese textile exports to the US will be allowed to grow at 10 to 16 per cent for the next three years. The deal came after protests by American textile producers and labour unions about the high growth of Chinese imports.
The surge of Chinese textiles into the US is part of a larger trade and macro-economic story. High growth of Chinese exports to the US has resulted in rising current account surpluses for China and deficits for US. By 2004, China8217;s current account surplus had risen to 4.2 per cent of GDP.
In July, the PBC revalued the yuan by 2 per cent to 8.11 yuan per USD, and announced that it would modernise the Chinese currency regime. A key element in the reform was proposed to be a shift away from pegging to the USD to pegging to a basket of currencies. However, in the following four months, the yuan has barely moved. In a recent study of the currency regime in China by Shah, Zeileis and Patnaik http://www.mayin.org/ajayshah/papers/CNYregime, the evidence suggests that China is just pegging to the USD 8212; not to a basket as claimed by PBC 8212; and that there is no gradual evolution towards a more flexible currency regime.
On the eve of George W. Bush8217;s visit to China in two weeks, there has been fresh criticism of the Chinese currency regime and renewed US pressure on China. What is in store will affect not just the US and China, but the whole world, including India. There are two alternative views for what might happen. The much discussed 8216;Bretton Woods II hypothesis8217; asserts that the system is presently in a sustainable equilibrium: we have a second Bretton Woods in which the Asian countries peg their currencies to the US dollar, and in which the US would run large current account deficits financed by official capital flows in the form of reserve accumulation from Asian countries. Others, such as Kenneth Rogoff, predict that there will be more action in the next 12 to 18 months. 8220;The first round of yuan revaluation won8217;t be over until the currency is up against the dollar by at least 10 per cent and probably more.8221;
We may hence expect that the coming year will see volatility in global currency markets. What can India do to prepare for this? Finance Minister P. Chidambaram is undoubtedly correct when he says that all is well with India8217;s trade account and currency movement. But all is not well with the US trade account, and the US dollar to which we peg!
It is important to see that what is going on is a global adjustment of trade, exchange rates, interest rates and capital flows. All these elements will adjust in bringing down the US current account deficit and the Chinese current account surplus. It is quite possible that there could be large changes in some prices, and large capital flows, in the adjustment process. Indian firms will undoubtedly get affected when this global drama plays out.
The traditional RBI response is to fall back on more controls. More capital controls will be brought in; and RBI will trade more intensively on the currency market; the rupee will move even less than it usually does. But these old-fashioned responses are increasingly out of touch with modern India. Capital controls come at a huge price in efficiency and corruption. RBI8217;s trading in the currency market comes at the price of RBI giving up its core task 8212; of a central bank which is running a domestic monetary policy which is best for India.
The right path consists of two elements. First, the Indian rupee should be more of a market determined rate, so that the private sector is not given false expectations about currency risk. At present, RBI intensively trades in the market to prevent the rupee/dollar rate from changing. This atrophies risk management in the private sector, as has been seen in the East Asian crisis. We need a more flexible currency regime, so that the private sector knows that it has to take care of itself.
Second, this needs to be accompanied by currency futures trading, so that the private sector can protect itself from currency risk. Indian firms should face an environment just like that seen in other market economies, where there is a flexible exchange rate, and a well developed currency derivatives markets.
India has a lot to learn from the PBC in terms of policy analysis and preparation. Since the revaluation, the PBC has slowly and steadily announced a number of measures that aim at building a foreign exchange market and developing instruments of hedging foreign currency risk. PBC is working with the Chicago Board of Trade to start a currency futures market.
India is in good shape, in having sophisticated derivatives markets being operated through NSE, BSE and SEBI. It is easy to start currency futures trading using these three institutions. India can do better than China in this regard, thanks to this sophisticated institutional capacity which has come about over the last 15 years.
This discussion is not new. From 1993 onwards, there has been talk in India of a more flexible exchange rate coupled with currency futures trading. But RBI has been trapped in its dependence upon controls. There is an urgent need for action, given the present situation in the global economy. If there is political will to think in ways that break with the traditional control raj mentality, then India can achieve dramatic progress in a short time.
