Don’t lose sleep over RMB devaluation

By: and |
Updated: August 20, 2015 1:05:12 AM

Geopolitical differences between India and China are getting stronger. Opportunities lie in enhancing bilateral investment flows

India’s trade deficit widened to $12.8 billion in July. Exports posted a contraction for the eighth consecutive month. The recent devaluation of the renminbi (RMB) has sparked fresh concerns with regards to its implications for India’s exports and trade deficit. “As China is maintaining a relatively large trade surplus, RMB’s real effective exchange rate (REER) is relatively strong, which is not entirely consistent with market expectation. Therefore, it is a good time to improve quotation of the RMB central parity to make it more consistent with the needs of market development,” People’s Bank of China (PBoC) recently said in a statement.

PBoC devalued the RMB by 1.9%. Earlier, PBoC announced the “daily fix”—the midpoint for the currency, which was then allowed to trade within 2% in either direction. Now, as per the statement, the daily fix will “refer to the closing rate of the interbank foreign exchange market on the previous day.”

PBoC has pointed out that the REER (exchange rate adjusted for inflation and productivity across trading partner countries) appreciation is not entirely consistent with market expectations. REER has appreciated by 14% in the last one year and hit Chinese exports adversely. Since June this year, the RMB spot rate has consistently been 1.5% higher than the daily fix. With this move, PBoC seeks to fix the discrepancy and make the currency more market-oriented.


The devaluation comes at a time when Chinese exports have been falling—contracting 8.3% in July. For the three months ending July, exports contracted 2.8%. The devaluation will provide support to the slowing Chinese economy by making exports cheaper. However, with the devaluation, other emerging market currencies too have depreciated, thereby shaving off some of the price competitive advantage of Chinese exports.

Indian export growth has remained in the negative territory since December 2014 on account of weak economic conditions in the major export markets—the US and EU—and low oil and commodity prices. While the price elasticity of India’s export basket has reduced over the years, RMB’s devaluation could have an adverse impact. With a weak RMB, price competitiveness of Indian exports will take a hit, making Chinese imports cheaper than domestic goods and can further skew bilateral trade balance in favour of China.


India’s trade basket with China differs sharply from what it trades with the rest of the world. Chinese imports into India have a higher price elasticity as compared with India’s exports to China. The composition of bilateral trade flows seems to be lopsided. Raw materials such as copper, ores, mineral fuels and cotton constitute almost 50% of India’s exports to China. While India mostly imports manufactured and capital goods from China. This trade asymmetry has been a cause of concern for our policy-makers. While India’s exports have diversified over the past decade, both in terms of product range and destinations, China has yet to emerge as an important destination for high-value-added products.

Bilateral trade has increased over 20-fold in the past decade, from a mere $3 billion to $65 billion in FY14 and $72 billion in FY15. China accounts for around one-third of India’s total trade deficit—trade deficit with China stood at $48.4 billion during FY15, swelling by 34% as compared to the previous fiscal. While India’s exports to China contracted by 12.5% during FY15, imports surged by 19%. The RMB devaluation will put pressure on the rupee as bilateral trade deficit with China will further worsen, not just because of export slowdown but more because of the import surge from China. This is because China’s imports into India have a higher price elasticity as compared to India’s exports to China. Sensitive sectors which could be hit from import surge would be metals, electronics, textiles and machinery. Indian industry has often raised concerns about the widening trade deficit restricting market access in areas such as IT, pharma and agricultural products.


Further, India’s export competitiveness, especially in the manufacturing sector, lags behind China. UNIDO’s Competitiveness of Industrial Production Index measures “the ability of countries to produce and export manufactured goods competitively”—with 1.0 being the best score. India’s CIP score was 0.07 in 2010 compared to China’s 0.33. A depreciated rupee may provide some price competitiveness to Indian exports, but RBI may not tolerate a weaker currency if it starts impacting inflation adversely.

Chinese non-tariff barriers make it difficult for India to export to China. Anti-dumping duties, technical trade barriers, sanitary and phytosanitary issues, operations of state-owned enterprises, customs processes, export restrictions and IP protections are examples of such barriers.

The Chinese currency remained undervalued for quite some time. As a result, Indian consumers and businesses were enjoying deceptively cheap Chinese imports. However, in May this year, the IMF said the Chinese currency is no longer undervalued.

Although lopsided, the bilateral trade between India and China can be viewed in a positive light as well. In fact, India’s massive infrastructure deficit has resulted in the rise of capital imports from China. This has accentuated because domestic manufacturers cannot compete with Chinese manufacturers both in terms of quantity and price. By importing low-cost capital goods from China, India is fixing its infrastructure deficit.

Will an India-China FTA help? A study by Bhattacharya and Bhattacharya delves into the likely impact of an India-China trade agreement using a Gravity Model. It shows that maximum gains of the FTA will likely accrue to China because of its lower tariffs. If there is free trade between the two countries, the simulation results show that India’s exports to China will increase by 45.67%, whereas India’s imports from China will increase by 110.37%.
Given the ballooning bilateral trade deficit with China, it warrants the attention of policy-makers. India’s comparative advantage in services and huge need for capital requires a trade strategy involving comprehensive pacts that cover goods, services and bilateral investments, particularly in negotiations on the proposed RCEP—a grouping that comprises the 10 ASEAN members, Australia, New Zealand, India, China, Korea and Japan. China’s use of non-tariff measures and circumvention of rules of origin also needs a serious review.

Geopolitical differences between the two countries are getting stronger and opportunities lie in enhancing bilateral investment flows. Chinese investment accounts for 0.4% of total FDI into India, even with China’s outbound FDI on the rise. Indian investment in China is even smaller. However, few steps have been taken to boost bilateral investment. The NDA government has accepted 18 applications from Chinese firms since June 2014 to set up bases in India. These are in sectors including power, construction, petroleum, airlines and tyres.

There is significant scope for bilateral cooperation in the services sector. India has made substantial upgrades to its services industry, especially in IT, and has also carved out a niche for itself in the pharma industry.

If the two nations work in close cooperation, they can surely propel themselves to a higher growth path and serve as growth engines to the world. More than the trade deficit, it’s the “trust deficit” which matters for the two Asian giants.

The authors are corporate economists based in Mumbai

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