Revaluing pain with someold-fashioned solutions

The world looks on as sordid tales of assorted negotiations and arm-twisting manoeuvres between the United States and China on the dollar-yuan exchange rate issue continue in the financial press.

Yet little really has been offered on how the ongoing US-China dynamics ought to be perceived by the rest of the world. This is particularly so, because the dollar-yuan rate has spillover effects that impact the fast growing emerging markets. These markets remain vulnerable — should the present status quo change — to the impact of subsequent exchange rate realignments due to a complex interplay of incentives, bad habits and expedient policy decisions made since 1994. Back then, the yuan was devalued by 50 per cent against the dollar.

As per the World Bank, for 2011, East Asia is estimated to grow at 7.8 per cent, South Asia at 8 per cent and even the Middle East chips in at 4.3 per cent. The single biggest characteristic of all these economies has been that they have been competitors with Chinese products and services in international markets.

So components of these growth figures are attributable to these countries adopting policies analogous to China. As a result a number of countries have also adopted active-intervention in the foreign-exchange market as a de facto policy, even if de jure they have free-floating exchange rates.

Insufficient reserves

This is typically true of the South East Asian tiger economies, who have all run astonishingly mercantilist trade policies aided by cheap domestic currencies. To an extent, their behaviour is understandable given the thrashing their economies got in the late 1990s meltdown courtesy, in parts, to insufficient foreign reserves.

The result of this has been the creation of an export sector in those countries that survives despite low margins thanks to devalued currencies. Any appreciation of the domestic currency will result in substantive economic damage and the prospects of social unrest aren't too farfetched either.

Another critical aspect is that should the Chinese allow (or be forced into) revaluing the yuan — the other countries that have hid (so far) behind the aprons of Chinese policy will have no recourse but to revalue as well. With virtually no teeth, the US House of Representatives has passed the so-called Ryan Bill that allows firms to register complaints against unfair trade practices by the Chinese.

Nevertheless, should the Americans manage to get the Chinese to revalue, it is not hard to see how they might convince the Thais, Koreans and others to follow suit, with or without gunboat diplomacy. Despite the fact that most estimates are largely meaningless, it is not hard to foresee countries that will have to revalue anywhere from 10 to 30 per cent against the dollar or euro. The impact of this revaluation is that the import bills of many countries, thanks to oil and gas imports, will skyrocket. Concurrently, should there be a supply shock, the prospects of inflation are well within anybody's imagination. This is particularly true for small open economies like Thailand or South Korea.

Inflation can lead policymakers to choose between the lesser of two evils, neither of which is preferred by the electorate at large. India, for example, has suffered a serious bout of a medium level of inflation (with food inflation exceeding annualised rates of 15 per cent in some months) thanks in part to structural deficiencies and interest group capture of the food production and distribution system.

Countries that, like squirrels in winter, prepare today will be in a position to capitalise as others stumble tomorrow. Nature and global econ-omics can be stunningly simple. Sometimes.

The columnist works for a major European investment bank in New York City. You can follow his tweets on http://twitter.com/ks1729