R Ravimohan: Having the Chinese cake and eating it too!

China has turned its dual currency system to good account.

The Chinese renminbi has overtaken the Hong Kong dollar as the stronger currency and is currently quoting 0.996 to 1 HK dollar . This piece of news seems to have generally been ignored by most of us. However, is this event as innocent as it appears on the surface? Five historical factors and three potential impacts for the future I think make this a worthwhile subject to delve into.

China is the only country in the world to have two currencies. It can strategically play this uniqueness to its advantage by balancing the weakness of one currency to promote its exports, while using the strength of the other for attracting capital flows.

China floated the renminbi recently in response to widespread accusation that it was artificially keeping its value weak to help itself become a dominant exporter in the world.

China has one of the largest economies in the world, which is also one of the fastest-growing. Any slowing down, especially fast, will be disastrous for China.

While the Sino-British Joint Declaration (based on the "one country, two systems" idea)""the treaty governing the transfer of Hong Kong back to China and how the Special Administrative Region (Hong Kong) will be handled""remains in force, it is unclear as to what deterrents exist to prevent the Chinese authorities in considering holistically the management of its monetary policy for the country as a whole, rather than pursuing a dual monetary system as it is apparently doing now.

As a global super-power it will only be appropriate for the Chinese currency to be counted along with US dollar and the euro as global reserve currencies.

The development will carry three impacts:

On the currency market the debate will be on whether the Hong Kong dollar's peg to the US dollar will be loosened and, therefore, bringing on a whole new element to speculate upon.

If China plays its dual currency to its advantage both on the export front and on promoting a strong global reserve currency, then it might prompt an international howl of political protests, prompting some new changes to market systems or even possibly force a unification of the currencies.

Alternatively, there would be moves by each country to float multiple currencies to serve its various goals!

Given the major impact this will have on our markets, let us understand what China's motivations and possible courses actions are. The Chinese economy benefits from, and simultaneously depends on, the triple drivers of exports, foreign direct investment, and burgeoning domestic consumption. A weak currency helps exports, but hurts domestic consumption as it renders goods more expensive and also hurts foreign direct investments since the returns on those net of the currency depreciation make FDI less attractive. Given the positive trends in the FDI flow and the buoyant domestic market, China should now be preoccupied with promoting its exports. However, a constantly weak currency will also not serve China's desire to have its currency attain the position of a world major reserve currency. Also in future, when it needs to shore up the FDI, or when the domestic market witnesses inflation, it perhaps might want a strong renminbi. Of course, to combat inflation it could tighten money supply. The resultant pressure on interest rates would be an unwelcome, additional burden on the banking system that is yet to clean up its massive bad assets. China will benefit greatly if it were, therefore, able to both appreciate and depreciate its currency simultaneously to keep both its exports and domestic consumption going. How is it physically possible to both appreciate and depreciate its currency at the same time? Well anything is possible for the Chinese!

This is where the magic and the power of the dual currency come in handy to the Chinese policy-makers. A weak Hong Kong dollar helps in pushing all exporters to quote prices in HK dollars rather than the renminbi. Over time, Hong Kong might become the gateway for all Chinese trade. The renminbi strengthens as desired by the world and China will be seen as a fair global power; China can then concentrate on promoting the renminbi as the one of the three global reserve currencies! If the Chinese manage the transfer of forex reserves internally between its own state and centre in a federal accounting system that is known only to them, as indeed how the federal accounting of all countries in the world are managed, then the problem of trade surplus pushing the Hong Kong dollar up will also be muted. For instance, in India the state deficit is sequestered away and is not counted in the central deficit by this opaque method of federal accounting. In a similar way, the internal transfer of reserves and fiscals between the Chinese central fiscals and those of one of its own states called Hong Kong will be governed by its internal methods and not dictated by the pressures of the world. This arrangement also supports the continued peg of the Hong Kong dollar to the US dollar, as it naturally protects China from the US tactics of artificially weakening its dollar to blunt Chinese export competitiveness.

This looks too good for China, and really bad for the rest of the world. So obviously the rest of the world will react in one of the two ways. Either they will again pressure China to abandon its dual currency system, failing which they will also begin the process of "dualling" currencies! China certainly has a lot of international precedents to dive under to protect its dual currency system. For starters, the Sino-British Joint Declaration perhaps would require them to maintain this for a certain period. Those of the lesser countries that do not have dual currencies to play with have for eons "sterilised" their inflow to keep currencies from appreciating and kept inflation under check. The world might find this little precedent coming in their way of disciplining China from doing the above trick. Therefore, it might adopt the alternative of designating a special currency for current account transactions and a stronger national currency which will reflect its standing in the comity of nations! Be prepared, therefore, to begin complaining about cheap imports from Hong Kong as opposed to cheap Chinese imports, continued HK dollar peg to the US dollar, and perhaps for Mickey money from the state of Florida!

ravimohan@crisil.com