The Chinese believe in more substance than sound. When they wish, however, they can make it the other way round. An equally important trait in their approach to international relations is this: even when they, uncharacteristically, decide to respond to external pressure, they take care to protect, if not promote, their own interests.

Both these traits were visible in the recent change of stance in China’s exchange rate policy.

The real highlight of the recent G20 summit in Toronto is not the predictable posturing of the leaders on dealing with fiscal deficits, but the absence of any reference to China’s exchange rate policy.

Clearly, China wanted the spotlight at the meeting to be on issues such as European debt crisis and rising budget deficits in Europe and the US, which threaten to erode the value of its foreign currency reserves in excess of $2.4 trillion. This is exactly what happened. As always, the Chinese outsmarted their critics.

China has faced severe criticism in the last few years from the international community for keeping its currency, the yuan (also called renminbi), artificially cheap by effectively pegging it to the dollar. Policy makers of the rich countries had been nudging China for months to float the yuan.

On 19 June, China responded to these pressures in its own way. The People’s Bank of China announced it would increase the “flexibility” of its currency, signalling an end to the dollar peg and a willingness to let the yuan appreciate. The value of yuan will now be guided, said PBOC, by a “basket of currencies”, not by dollar alone. However, it ruled out a one-off revaluation as unwarranted. It pointed out that China’s controversial current-account surplus has narrowed over recent years, from 11 per cent of GDP in 2007 to 6.1 per cent of GDP last year.

Notice first the ambiguity of intent, allowing ample elbow room for manoeuvre. The 19 June statement was as vague as the Chinese could make it. It pledged to keep the “RMB exchange rate basically stable at an adaptive and equilibrium level”. Another statement followed on June 20 (in Chinese only) reassuring everyone that basic stability would be safeguarded.

Then again, the timing of the move was carefully chosen. It came roughly a week before the G-20 summit in Toronto, where pressure on China to adopt a more flexible currency regime was expected to intensify. China pre-empted some of this by agreeing to more exchange flexibility. To further dampen criticism, on June 25, China's central bank set yuan exchange rate at 6.7896 to a dollar, the strongest in several years, ahead of the weekend G-20 summit.

The decision to make yuan more flexible was hailed both by the governments and financial markets as a positive step. Diplomats were more cautious in their response, insisting that China must match its words with action. Financial markets were more unequivocal in welcoming the Chinese decision. On Monday, 21 June, yuan edged up from 6.83 to 6.8010 to a dollar. Stock and commodity prices rose as did the sentiment about the prospects of global recovery.

The BSE Sensex gained 305.73 points on Monday (21 June) to close at 17,876.55, while the Nifty gained 90.7 points, to 5,353. The rupee spurted to 45.74 against the dollar, up 45 paise from Friday’s close of 46.19. Later in the week, stocks and currencies surrendered part of their gains as the vague and limited nature of the “flexibility” sank in and other factors (e.g. US housing data) intervened. The Sensex ended the week flat and rupee 10 paise lower against the dollar.

No one can accuse China of neglecting its national interests. While China has committed to dropping its de facto dollar peg (6.83 yuan to the greenback) that it has maintained since mid-2008, it has not promised either a one-off revaluation against the dollar or a free-floating currency. It will continue to “manage” its currency through heavy intervention by its central bank. Thus, a sharp appreciation in the yuan against the dollar is unlikely.

Then again, a more flexible yuan offers China more tools with which to cool its economy and tame inflation. It would help China stem the flow of hot capital into an economy that is prone to sudden jumps in stocks and house prices. A stronger yuan would cut the costs of imported goods. Even better, abandoning the fixed tie with the dollar has liberated China’s interest-rate policy.

For America and Europe, a floating yuan will hopefully kick-start domestic manufacturing employment and exports, leading to the much-awaited recovery. US is looking forward to reduce its trade deficit with China, addressing global imbalances.

Will these expectations be fulfilled? Before one answers in affirmative, a few issues need to be sorted out. The first problem will be oil prices. On the heels of the Chinese announcement, oil and commodity prices rose. If the trend continues, prospects for recovery will take a hit on inflation.

Second, China is the principal creditor to the rest of the world, particularly the US and Europe. Its central bank has bought dollars and euros relentlessly to cap the yuan’s exchange rate. A flexible exchange rate regime would reduce the Chinese central bank’s need to intervene in the market. Its appetite for dollar and euro bonds will wane as a result. This could possibly push up interest rates in the G7 countries sharply. That could keep markets and policy-makers on edge.

Thirdly, correction of global imbalances will take more than an adjustment in bilateral exchange rates. It has been pointed out that unless America stops living off other people’s savings and learns to tighten its own belt, an appreciation of yuan by itself might only transfer the US trade deficit with China to other, probably higher-cost producers. Similarly, if workers displaced from China’s export industries do not find jobs elsewhere owing to the host of distortions and frictions plaguing its economy, a sharp appreciation of the yuan might result in a surge in Chinese lay-offs, and not a boom in Chinese consumption.

Finally, China’s growth model has been dependent heavily on exports that, in turn, have fed off an undervalued exchange rate. Greater exchange rate flexibility could dent exports. If domestic demand does not pick up to fill the void, then its growth might start sagging. An economic slowdown in China could worsen its labour unrest and create renewed social tension pregnant with political turmoil. And it will be bad news for the world economy and financial markets. 

What about India? India considers yuan flexibility a cause for celebration, especially for textiles and light engineering, it will have to compete with the western and east Asian economies which also have equally competitive, if not superior, manufacturing skills and technology in place, and will seek to occupy some of the space vacated by China.

Textiles are a classic example. China is the largest exporter of textiles and allied products in the world, while India ranks seventh. Along with its high productivity and supportive labour laws, China’s policy of keeping yuan undervalued has helped it to maintain its lead in the global trade. India’s textile exporters hope that China’s announcement of making yuan more flexible would lead to a level playing field and more orders in the coming months.

However, a majority of exporters are apprehensive about the extent to which China will implement its announcement and let the yuan appreciate. Others have expressed fears about the Indian industry’s capability to tap into such an opportunity. According to them, the pricing difference now is not that great and some large Indian players are actually very competitive. The real problem is lack of production capacities in India. This situation is similar to that in 2005 when the quota system was dismantled and China took over massive orders as it had been building capacities three years in advance. Indian capacities are not high enough to compensate the surge in orders deflected from China.

Weaker currencies are helpful only when the product is also constantly upgraded, a virtue that has served Indian software and ITES services well during the current recession. Exports have been the weakest component of India's GDP not because the rupee exchange rate is more volatile than its Chinese counterpart. Better infrastructure, sharply focused Special Economic Zones and a commitment to becoming the workshop of the world account for much of the difference between export performances of India and China.

The author is Executive Editor, Corporate India; he lives in Mumbai