China has been on a rate tightening cycle since October last year in order to tackle its stubborn inflation problem.
However the export oriented economy faces the prospects of a slowdown in exports due to the excruciatingly sluggish growth prospects in US and the sovereign debt crisis in Europe.
In such a scenario further hike in interest rates would cause more pain for the exporters, many of whom have quite a bit of political clout in the country. Moreover this might cause them to cut jobs which can lead to social unrest among people who are already battling severe food inflation.
Not many outside China understand how acute civil unrest is getting in the country and how concerned the Communist Party is about it. The gaping inequality among people is a major policy challenge for the China Communist Party. As much as the authorities tried, they couldn’t prevent millions of poor Chinese from coming to know about the public uprisings in the Middle East. These millions not sharing in the China boom, especially at times when food inflation is an issue, are capable of protesting sufficiently to cause problems. The combination of poverty, great income gap, hunger and lack of freedom of speech can be a deadly combination as leaders in Tunisia and Egypt have found out. I have been told that regular incidents of protest violence have occurred in China over the last 12 months, some of them bigger in scale than the recent London riots. However owing to media censorship, most of those stories haven’t made it to the western press.
So, don’t be fooled by the deprecation of the Yuan against the US Dollar over the last few days. The Yuan hasn’t depreciated; it is the US Dollar that has appreciated as investors took ‘flight to safety’ in these turbulent times. In the absence of their option to raise interest rates, Beijing shall be forced to appreciate the Yuan in order to counter inflation. The extent of appreciation shall depend on how much cushion do the exporters have for loss of cost competitiveness. China has been steadily increasing real wages over the last 18 months to stimulate domestic demand in the country. This has caused some companies to relocate their manufacturing facilities to even lower cost places like Vietnam. However faced with a choice between higher interest rates and a slightly appreciated Yuan, the exporters shall prefer the latter any day as a small rise won’t cause a big dent to their competitiveness. Also unlike economic arch-rival India, China runs a current account surplus and has room to appreciate its currency.
As far as the US goes, I have never really understood how they would benefit if China appreciates their currency. In fact the move would make ‘Made in China’ products more expensive for American consumers. The US Dollar depreciated significantly during QE-2 and that certainly didn’t cause an export boom in the US. But it seems to be a fad in America to blame China for all that has gone wrong with the American economy. What is worse? – Most of their citizens believe it. Maybe politicians now need to find another scapegoat as it shall soon become evident than an appreciated Yuan won’t increase US exports or add jobs to the U.S. economy significantly.
In the current environment, it is quite possible that export oriented countries shall enter into a ‘currency war’ as they compete with each other for a bigger share in the dwindling global exports. Investors seeking refuge in the U.S. Dollar shall put further depreciation pressure on the currencies of these countries. China however might not be able to join this bandwagon. Inflation and employment together would be too much for the country to handle simultaneously.
A gradual appreciation of the Yuan is their only way out.
Message to the US: China isn’t the cause of your problems and won’t be a solution to them either. Spoiling relationship with The Dragon in the current scenario can actually prove to be counterproductive for your companies who are looking at Chinese markets for growth. If you want to fix your house, get politics out of the way of economics.
Tanuj Khosla is currently working as a Research Analyst at 3 Degrees Asset Management, a fund management firm in Singapore. He can be followed on Twitter @Tanuj_Khosla and you can reach him at firstname.lastname@example.org. Views expressed are personal.