Finally, the much-awaited revaluation of the Chinese yuan happened last Thursday when the world was least expecting it. The yuan, also called the Renminbi, was de-pegged from the US dollar and from now on will be pegged to a basket of currencies.

In other words, theoretically at least, the value of the yuan would move in tandem with the values of the currencies of its largest trading partners. The composition of the basket of currencies has not been disclosed and going by the opaque ways of Chinese government it will remain a state secret.

The Chinese government also announced a marginal revaluation of 2.1 per cent for the yuan against the US dollar. The more than a decade old rate of 8.28 yuan to a dollar was changed to 8.11 with effect from Thursday the 21st of July.

The move came after relentless pressure from the US, which accused the Chinese government of enjoying an unfair trade advantage by keeping the currency undervalued. An undervalued currency means exports from the country would be cheaper in overseas markets while imports into the country would be costlier making it difficult for overseas companies to sell in the domestic market.

The calls for tightening the screws on China grew substantially in the US in recent months as Chinese companies moved in to acquire established US companies like Unocal and Maytag. There was talk of allowing these deals to go through, provided China allowed its currency to appreciate to the satisfaction of the US.

Two legislative bills were introduced recently in the US Congress, calling for punitive tariffs on imports from China if the yuan was not revalued. The proposed tariffs were as high as 27.5 per cent.

The last time the Chinese government changed the value of its currency was in 1994, when it devalued the yuan by 33 per cent against the US dollar. The performance of the Chinese economy in the intervening 11 years till now was nothing short of spectacular and beyond anyone's imagination back in 1994.

Between 1994 and 2004 the Chinese economy expanded three-fold from $540 billion to over $1.6 trillion, in absolute terms. Both exports and imports increased more than five-fold while trade surplus went up from $5 billion to over $30 billion.

Why revalue now?
The Chinese have always maintained that the fixed exchange rate has helped them enormously in weathering the Asian currency crisis of the '90s besides helping overall economic growth. The stable exchange rate did encourage large capital inflows from abroad which helped the country in building its infrastructure and manufacturing capacity.

The theory that the Chinese gave in to US pressure and revalued the currency is too simplistic. They are known to take aggressive positions when it comes to protecting their interests. Then why this revaluation now?

While the fixed exchange regime helped the country, it also brought in problems of another kind. It led to fiscal imbalances on the surplus side or a problem of plenty. The accretion to forex reserves in the last few years has been much higher than the FDI inflows. This suggests that short term money flows speculating on a possible yuan revaluation have gone up substantially.

Speculators bring in funds ahead of the revaluation to benefit from capital appreciation. A 10 per cent appreciation in the local currency would mean a 10 per cent return for the overseas investor. (Similarly, FII's investing in India benefit if the rupee appreciates against the US dollar, which may be the reason for a part of hedge fund investments in India)

Much of the economic growth in China is export led. After growing at a furious pace for over two decades, the government is trying to bring down economic growth to prevent overheating and ensure stable longer term growth. Despite their best efforts, exports rose to record levels in the first half of the current year and growth remains above 9 per cent.

The revaluation may make some of the low value added exports from China less price competitive in the international markets. Therefore exports of goods which compete only on price with very low margins may come down even if only marginally. More value added exports, which typically have higher import content or are less price sensitive, would be less affected.

How much further?
Most analysts expect the Chinese government to let the yuan appreciate further in near future. This is reflected in the non-deliverable currency futures market where yuan is quoting at around 7.75 to a dollar for 1 year forwards.

A 2 per cent appreciation can hardly make any difference to the fiscal problems faced by China. It may in fact make matters worse by attracting more short term inflows in anticipation of a bigger appreciation in future. Therefore, analysts believe that bigger revaluations would definitely follow.

However, the Chinese government has dismissed all such speculation about further appreciation of yuan. It has categorically stated that no further revaluation is being considered in the near future.

A bigger appreciation in the value of the yuan, say by 10 per cent, could lower the economic growth in China by up to 2 per cent. Most of this slowdown would happen in the form of lower exports of less value added labour intensive goods.

China has to maintain sufficient growth in employment to address the regional disparities and the growing aspirations of its people. It can ill afford a sudden drop in growth rates and employment which could potentially lead to political and social unrest.

Unlike India where citizens demand a lot from the government but do not expect much, the Chinese expect their government to deliver though they may not demand publicly. Chinese politicians would know very well that the stability of their political system depends on managing rising expectations.

A 10 per cent appreciation would also mean a large capital loss on China's bulging forex reserves. Assuming that a large part of its reserves are invested in dollar assets, the loss could be in the region of $50 billion. Even China cannot afford such losses.

Therefore, it is difficult to believe that the Chinese would let the yuan appreciate substantially and suddenly. The currency would most likely appreciate, but it would be a slow and highly measured process.

Impact on global economy
The Americans have been the most vocal in demanding the revaluation, but ironically they are likely to suffer much of the pain in the short to medium term if China is to satisfy their demands. Americans have been blaming the Chinese for most of their economic ills while enjoying the benefits of low priced imports from China and other Asian countries.

One of the significant factors keeping US consumer prices down is the low cost imports of consumer goods from China. Wal-Mart and other discount stores would not have been half as successful without these cheaper imported goods.

Besides supplying the US with low priced goods, the Chinese and other Asian governments finance this US shopping binge by buying dollar assets, mostly US Treasuries.

A more expensive yuan means higher prices for Chinese goods which would in turn put pressure on US domestic inflation. This would lead to higher interest rates which would affect the real estate boom in the US, one of the prime drivers of economic growth there.

A large fall in the value of the dollar would force most Asian central banks to move out of their dollar assets. This would in turn dry up liquidity in US and push up interest rates and further increase inflationary pressure. This would be the case if the yuan is to appreciate the way the Americans are demanding. Ironically, this is the ideal solution to correct the fiscal imbalances in the US.

In the short to medium term this is less likely to happen. Instead, liquidity flows into China and other Asian countries would rise in anticipation of further appreciation in Asian currencies. The central banks of Asian countries would mop up these flows to prevent their currencies from appreciating and hence would accumulate more dollar assets. Therefore, the unsustainably high US current account deficit would remain high till the US economy makes the structural adjustments.

The higher liquidity flows into Asia would keep interest rates in the region under check. Even a marginal slowdown in the Chinese economy would ease the pressure on regional inflation through lower prices of commodities and other inputs.

A less vigorous Chinese economy would also have a significant impact on crude oil prices. The current record prices have a significant speculation premium, betting on sustained growth in demand from China and India. On the first indication of a slowdown in Chinese demand, much of this premium would disappear.

Impact on India
Apart from some low value textile goods which are highly price sensitive, no other segment of the Indian industry is likely to benefit significantly from the marginal appreciation of yuan.

Commodity exports like iron ore, finished steel and other metals could theoretically benefit from the lower costs for Chinese importers after the currency appreciation. However, the positive impact would be more than offset by the downward pressure on international prices of these commodities when Chinese growth slows down.

India could benefit much more if western importers start sourcing more from the country to reduce their risks. Uncertainty over the Chinese currency may encourage some of them to build deeper relationships with Indian suppliers as a longer term strategy, even if Indian exporters are less price competitive.

More significantly, US and European manufacturing companies may now look at India as an alternate location for future plants. Further appreciation in the yuan would make low margin manufacturing and assembly operations in China less attractive.

Initial signs of this are already visible with large electronic contract manufacturers coming up with plans to start operations in India. Even chip manufacturers, including Intel, have started looking at India favourably.

However, all these potential benefits would accrue to the country only if we get our act together on the critical issue of infrastructure.

We should also pray that the yuan would neither appreciate too fast nor too slow. A sharp appreciation could be too disruptive and harmful for the entire region while a very slow movement would not be disruptive enough to offer us any competitive advantage.