You might have observed the first trade deficit (in first quarter of 2010) of China in the last seven years. Why has it happened?

Does the rapid growth of China will come to an end soon?

Will Chinese goods be no longer cheaper?

May be, it can happen in very near future. If you want to know why it is so, and what is happening with china just read this article. I felt the CURRENCY WAR IN CHINA would be the well suited title for this article. You’ll understand same by the end of this article.

The reforms in People ’s Republic of china has started in 1978, a decade ahead of us, which gave an advantage for them. From there onwards china has developed rapidly. The GDP, in the year 1978, was just below 370 billion RMB (Renminbi, primary unit of which is called as Yuan), while that value reached 33,535 billion RMB in the year 2009. That means it has grown by 90 times in the period of three decades. In the first quarter of 2010, china has declared a trade deficit of $7.2 billion, first time in the last seven years. Was that a strategic move or china is losing its grip as the fastest growing nation in the world.

Just observe the graph below,

 At the first glance itself you can identify that the china’s currency value was almost same for a decade (ranging from 1994-2005) against dollar. Does that mean the china’s Yuan is all above the fluctuations of currency? The answer will be no. To understand this, one must understand the foreign exchange policy of a country. A country can follow fixed exchange rate system (or pegged exchange rate system) and a floating (or fluctuating) exchange rate system. In simple words, in fixed exchange rate system, the value of the currency will be determined against some box of currencies with which that particular country trades. China pegged its Yuan against dollar, which caused constant exchange rate throughout that decade. Floating exchange rate system is one in which the value of the currency will be determined by the demand and supply of that particular currency, which is more dynamic in nature. China changed its exchange rate system from fixed exchange rate system to controlled floating exchange rate system in the year 2005. You can see from graph, the value of Yuan was changing from 2005. Though it is fluctuating, the fluctuation is not at the market levels. Take an example of rupee or dollar or any currency for that matter, the value of dollar, for instance, fluctuated heavily in the last 6 years. Yuan has not fluctuated heavily because it is following the controlled floating exchange rate system.

Let us get it in simple terms, china is majorly dependent on manufacturing sector. China is producing more than what it needs. That means, it has surplus production with which it will export goods. If the currency value is lower, the exporter will get more money. Take an instance for your better understanding, exchange rate of 1 dollar = 6 Yuans. If china exports $ 1000 worth of goods, it will get 6000 Yuans. For example the exchange rate has appreciated to 1 dollar= 5 Yuans, China will get only 5000 Yuans of same worth of goods export. For the country with the trade surplus (exports>imports) , it is better to maintain low exchange rate(6 Yuans, in this case).

 If a country is growing, more investors, like FIIs, will come to that country to invest and to encash that growth. If there are more investors, the demand for that particular currency will be more which will result in appreciation of that currency. But China doesn’t want to appreciate its currency because that will result in less inflow of money. To control the appreciation of Yuan, china avoided the FIIs to participate in their stock markets. Unlike inida, china’s growth is not driven by FIIs. And one more they did to control the exchange rate of Yuan against dollar was they invested heavily (almost 9% of their country’s economic output) on purchase of foreign reserves. That means they created demand for the other currencies, which will automatically result in depreciated Yuan. Till date, the story ran in favourable to them, they achieved what they expected.

 But the story has started to change rapidly, which caused the things to go out of china’s hands. The labour in china demanded in hike of their wages, which resulted in high production costs. The inflation started to rise, which reduced the purchasing power of their people.  There has been high political pressure on china to allow their currency to fluctuate, mainly from US. Both the countries’ presidents met several times in the last few years. Cheaper exports from china made US companies to shut their industries. On the other hand, costlier imports from America had less demand in china. Both the ways America lost to china. But with the rise in inflation and production cost, china could not able to cope up with standard exchange rate without losing the purchasing power of their people. China had let to go Yuan with the fluctuating value of the currency as the interest returns on the foreign reserves were very less. It had been like a dead asset for them. Moreover, they needed more money to complete their on-going projects and to take up new ones. All these causes left china no other option apart from the appreciation of their currency. Renminbi has already risen with the dollar by 15% against euro in the last two months.

Now the question is how it is going to affect their economic growth? Though the question is very simple, answer could be very complicated. Appreciation of Yuan made imports cheaper for Chinese, which will create more demand. At the same time the production costs for indigenous products had risen, caused rise in the price of end product. Just assume that you have to choose between two jean pants one is made by Levis which costs at Rs.1100 and another which made by Aravind mills which costs around Rs.1000. The general human tendency will choose Levis one though it has priced higher compared to that of same quality pant which is priced low but manufactured locally. China is going to face the same problem. There is going to be lower demand for the indigenous products and higher demand for the imported goods. But this will certainly increase the purchasing power of China and will help curb up the inflation.

The importers from china and exporters to china have a last smile, but no one knows how far it’ll last. The future of china is still uncertain, as the companies are started to move out of china to Bangladesh and other countries where the labour costs are still lower. But at this junction point, no one can able to judge the future of the china apart from some speculations. Even this will benefit India also, as india is one of the major trading partner of china.

Wait and see for one bolder move from China, as it has been doing for the decades.

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