Tuesday, October 23, 2007

Revaluation of the Yuan...

Given the generic consensus at the G7, US Congress, Rest of the World barring for Sudan and Myanmar that the Yuan is under-valued against all global majors, particularly the USD – it is a question of when, rather than if at all, the Yuan will be revalued. Given the smooth change of guard at the Communist party meeting – it seems fairly certain that the Yuan will be revalued, perhaps not as much as the Treasury officials deem necessary, but in the “right” direction. What does this do to global trade flows?

Some preliminary conclusions/thoughts/conjectures are:

1. The econometric evidence on the contributions exchange rates make on competitiveness, productivity investments and thus, trade surplus in China is too varied to really be of much use in a week-on-week assessment.

2. One estimate is that the Yuan is undervalued anywhere from 0-50%! Assuming it is 50%, and all other costs remain constant, a 50% revaluation (entirely unlike) will affect varying sectors of the economy differently. So, prices observed in the imports will change according to the demand elasticity for given price change. So, in the countries that import low-complexity Chinese commodities -- pencils, mousepads etc., -- there will be a substitution effect in display.

3. Standard trade theory predicts that as Yuan is revalued, the level and growth rate of the Chinese exports should decline. However, it is important to note that most international trade contracts are 6-12 months set in advance. So a container of toothpaste to be delivered at Seattle port set at 1USD, will make the Chinese exporter temporarily better off. In contrast, US exporters of products invoiced in Yuan, will be worse off given the new USD-Yuan rate. The trade deficit numbers will do exactly the opposite as Washington expects in the two-three month period. (The opposite of a J-Curve observed during a devaluation.)

4. What a Yuan revaluation does to non-USD currency majors – is very much contingent on the competition for products in domestic markets and in third-party markets.

5. The supply change management in place for goods to and from China is a well-oiled machine, and changing trade flows will take longer than perhaps one anticipates. There are economies of scale in place and productivity gaining measures in place – that the willingness to abandon China as a primary sourcing place is unlikely to change all that much. Of course, the trade deficit numbers will seem more palatable for political purposes, but whether a substantive quanta of imports declines is unlikely.

6. All of the above assumes the Chinese will continue to produce as always. Then the improvements in the Yuan will provide the results Washington wants. But, all that is unrealistic. If the pricing pressures increase on Chinese products, then it is silly to not expect them to improve their productivity.

7. The most understudied aspect is that when the Chinese exports decline (and thus their income declines) – the effect on goods imported to China. It is easily conceivable that services from India and Europe can replace services and goods offered by the US. The elasticity of Chinese imports to income changes is perhaps the most important, and unclear, aspect of this whole issue.

Now what? When revaluation happens, for a short while the USD will rise, Euro will fall against the USD and the Yen will rise as well (if the USDJPY tracking of 6M USDCNY forwards are to be trusted!).

But, in the intermediate term after the revaluation we will be back here -- singing the same tune.

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