On April 30, the Chinese yuan went out of its government mandated trading range. Currency markets around the worl braced for impact. What the hell does that mean?
China, like India has always believed that a free floating currency is not advisable till the country’s industrial and knowledge base is mature enough to act as shock absorbers. In India’s case, the rupee is allowed a little more variation than what China allows its yuan. For example, India’s Reserve Bank buys, billions of dollars every day to stem the fall of dollar vs the rupee (This data is maintained by the Bank of International Settlements). The rupee is pegged not against the dollar, but against a basket of international currencies. The Yuan on the other hand is pegged against the dollar at approximately 8.2760 to 8.2800 yuan/dollar. As mentioned previously, this figure is maintained by the Chinese central bank by buying up dollars. On the 30’th, this exchange rate went to 8.2700 per U.S. dollar, making the yuan much more expensive.
The American Federal Reserve and the G-7 nations are not happy. This is because China and India are the biggest foreign markets for investment. Now as more and more FDI (foreign direct investment) flow in, the central banks buy more and more foreign exchange. This foreign exchange is now re-invested in the US in Treasury backed US Govt. bonds. As a result of this massive investment, the rate of returns decrease for everyone holding the same family of bonds. Now several G-7 countries hold massive amounts of US Treasury bonds and they are not happy about the decrease in the rate of interest.
India, like China, is struggling with a system to maintain control even in crises. We certainly dont want another Asian meltdown. Very recently, the Indian Finance Ministry toughened the path to borrow dollars on the international market. This is part of its effort to reduce FDI. This has not gone well with small Indian businesses who are justifiably wary of any governmental control over business. Therefore the government is now trying to reduce customs duty to decrease the supply of dollars in the country.
But one thing is for certain, India cannot remove the peg on the rupee unless it is assured the yuan will behave the same. It is estimated that the yuan is undervalued by almost 40 %. We buy education, technology and iPods. If the US govt. makes it difficult for Indian students to go US univs. or the Indian govt. makes it difficult to import laptops, this situation will be gridlocked. But the problem is, atleast the government feels, that opening up import trade will harm local manufacturers who have not matured to global economies of scale. Is that true - only time and China will tell.
UPDATE: Traders are buying up forward contracts of yuan (i.e. a piece of paper that allows them to buy currency at a value fixed now, often by offering the seller a premium)which shows that they expect the yuan to trade upto 5.8 % higher in a year.