Tuesday, November 30, 2010

G-20 unfair to developing countries

Economy Watch

By Dr Bharat Jhunjhunwala


The stand-off between United States and China regarding undervaluation of the yuan can be understood by an example. The village landlord was buying milk from the milkman. Land reforms led to reduction of the landlord's income and it became difficult for him to pay for the purchase of milk. Instead of reducing his consumption of milk, the landlord wrote and gave promissory notes to the milkman and continued to consume large quantities of milk as previously. In this way large amounts of promissory notes were accumulated by the milkman. The landlord then began to feel threatened that the milkman will demand payment of these notes and may seek control of his grand mansion. To escape from such an eventuality the landlord accused the milkman of selling his milk cheap; promoting excess consumption of milk in the landlord's household and thereby pushing him into indebtedness. Obviously, the landlord's accusation is false. Instead of reducing his consumption according to his reduced income, he is accusing the milkman of selling milk cheap.

The stand-off between America and China is of similar nature. America was importing consumption goods like toys, shoes and electronics from China and exporting hi-tech goods airplanes, satellites and computer servers. All was well. Then America launched wars in Iraq and Afghanistan and encouraged its citizens to borrow and buy housing. America could not earn enough from exports of its hi-tech goods to bear these expenditures. Unable to meet its ends meet, the American Government issued Treasury Bills to foreign investors and raised the money for these expenditures. Large amounts of these T-Bills were purchased by the Bank of China. In this way America continued to export less and import more. It incurred a large trade deficit. This sale of US T-Bills and other American property continues unabated today. America is becoming hugely indebted. Its economic sovereignty is threatened. China can sell these T-Bills in the market and cause their price to decline. This will lead to an equally steep reduction in the price of the dollar and cause a collapse of the American economy. Thus America is putting pressure on China to revalue the yuan so that Chinese goods become expensive in the American market; American people consume less Chinese goods and the trade deficit is controlled.

The exchange rate of yuan has an important bearing on the price of Chinese goods in the American market. Presently one US dollar is exchanged for about six yuan. Say, the cost of production of pencils is similar in both America and China. American companies sell six pencils for a dollar while Chinese companies sell one pencil for a yuan or the same six pencils to a dollar. The American consumer may buy six American or Chinese pencils for a dollar. Now, let us say, the price of yuan is reduced and one can get eight yuan for a dollar instead of six at present. Now the American consumer can get eight Chinese pencils for a dollar against only six American pencils. Chinese pencils have become cheap and Americans will consume more of them. All Chinese goods have become cheap in the American market similarly because of such change in the exchange rate. American factories have started to close down. Thus America is asking China to increase the price of yuan so that the trade balance is reduced and American economy is saved.

The trade balance is automatically settled in normal circumstances. Say China exports more and imports less. China will receive large amounts of dollars from exports while lesser amounts will be used in paying for imports. There will be an excess supply of dollars in the Chinese foreign exchange market. This will lead to a reduction in the price of dollar vis-à-vis the yuan. American goods will become cheaper in China and China's imports will increase. Simultaneously, Chinese goods will become expensive in America and their exports will decline. In this way the trade balance will be attained.

We must understand the resolution of G-20 that exchange rates should be allowed to be determined by the market in this background. Truly, the exchange rate of dollar and yuan is determined by the market even today, exactly as it is determined in India. However, the Bank of China manipulates the exchange rate by intervening in the foreign exchange market and does not allow the yuan to rise. Bank of China buys the dollars when export incomes are large. This leads to reduced supply of dollars in the foreign exchange market. Correspondingly the price of dollar increases and that of yuan remains low. Bank of China uses these dollars to buy T-Bills issued by the American Government or other property in the United States. In other words, exchange rate of dollar and yuan is already determined by the market as resolved by G-20. Problem is that the market-determined rate is being manipulated by Bank of China by purchase and sale of dollars in the foreign exchange market.

Real question, therefore, is whether Bank of China may purchase and sell dollars in the Chinese foreign exchange market or not? It seems issues such as foreign investment, maintenance of foreign exchange reserves and purchase of foreign currency for the same, level of domestic money supply and similar issues fall squarely within the ambit of a sovereign government. Remember that four years ago our Reserve Bank of India had made precisely such an intervention when the rupee was rising and our exporters were facing problems. RBI bought the dollars and prevented them from entering our foreign exchange market. This action of the RBI was called ‘sterilisation’ i.e., excess dollars were sterilised and made impotent to disturb our foreign exchange markets. Bank of China has adopted precisely such a policy. It matters little that RBI used this policy instrument for a short while Bank of China has been using the same instrument for years. The basic question of sovereignty does not allow making such fine distinctions. It is for a sovereign government to decide whether to buy dollars for one month or one decade. G-20 has no locus to interfere here.

America should reduce the wages of its workers in order to reduce the cost of production of its goods and to make them competitive in the global market. America should stop selling T-Bills and impose restrictions on sale of shares and property to foreigners. America should reduce domestic consumption to levels that are commensurate with its income. These steps would lead to elimination of that country's trade deficit. Correspondingly the trade surplus of China will also reduce. America is encroaching on China's sovereignty instead of taking steps to set its own house in order. This is like the landlord asking the milkman to increase the price of milk sold by it instead of stopping the writing of promissory notes....

No comments:

Post a Comment