7 September 2015

Can India make China sweat?

The longer China’s economic troubles persist and the longer it takes for the yuan to be part of SDR, the better it is for India

The government of India may not have sent a “thank you” card to the relevant committee at Morgan Stanley Capital International (MSCI) for its decision not to include China A-share indices in their benchmarks in May this year. Had it done so, international investors who use MSCI indices as benchmarks would have been forced to raise their allocation to China shares in the domestic market. They would have done so at the expense of their allocation to other emerging markets, including that of India. That did not happen and Indian stocks regained their footing after that decision, recent volatility notwithstanding. Subsequent actions by the Chinese government have vindicated MSCI. It is not clear if the International Monetary Fund (IMF) and its governing board will be as clear-headed.

China keenly desires its currency to be included in the Special Drawing Rights (SDR) basket of currencies issued by the IMF. SDR is an international reserve asset created to supplement the official exchange reserves of member countries of the Fund. When short of foreign exchange reserves, countries can exchange it for the freely usable reserve currencies that constitute the SDR. Right now, there are four of them—the US dollar, the euro, the pound sterling and the yen. The SDR basket comes up for review this year, perhaps in October. China is keen to be included and it is not just for bragging rights. Overnight, from being a nation with a heavily indebted and unbalanced economy, China’s status will be elevated to that of a reserve currency issuer. This is the equivalent of the transformation in status that the hero (played by Eddie Murphy) of the movie, Trading Places, achieves.

When a country runs a current account surplus, its foreign exchange reserves must rise. In China’s case, reserves, expressed in US dollars, have been declining. It is not just due to the depreciation of other currencies in its foreign exchange reserves against the US dollar. It must be the case that capital flight exceeds the current account surplus of China. The amount of money leaving China is big and rising. China is, therefore, desperate for capital inflows.

Why is China desperate for foreign capital inflows if its foreign exchange reserves are still around $3.6 trillion? A research note from Citigroup educates us on the level of comfortable foreign exchange reserves for a country based on the formula adopted by the IMF. The formula is a function of the country’s short-term external debt, imports, portfolio investments from overseas, etc. On that basis, the minimum level of foreign exchange reserves that China should be holding is around $2.6 trillion. The upper limit of the range is close to its current reserves holding of $3.6 trillion. China is not sitting pretty with its level of reserves. It needs a lot more of it. Incidentally, India’s current level of foreign exchange reserves is well above the safe thresholds set by the Fund.

What can be a more ideal time than now to be included in the SDR basket, which would compel central banks around the world to add the Chinese currency to their reserves? That will bring in much-needed foreign currency inflows into China to offset the capital flight. Thus freed of the worry of capital leaving the country, it will be free to choose the magnitude and timing of the devaluation. Citigroup economists put it very well: “Once a country can print a currency which is internationally accepted as a store of value, then its need for precautionary holdings of other countries’ reserve currencies 

will fall.” Freed of the obligation to maintain reserves, China can also pursue many more reforms in its factor markets and in the financial sector. Thus, the inclusion of the Chinese yuan in the SDR basket is China’s “get out of jail” card.

India must make China sweat for the yuan admission into the SDR basket as China has made India sweat for a seat in the UN Security Council and continues to do so. In the past, changes to the valuation of the SDR basket have been taken with a 70% vote. However, inclusion of a currency is different and India must work to ensure that the criteria for inclusion are not diluted and that it requires an 85% majority.

If required, India must be prepared to make concessions to the US in other areas for cooperation in this matter. It is good that Reserve Bank of India governor Raghuram Rajan made the intellectual case for the US Federal Reserve to go ahead with its rate increase sooner. It helps. To the extent that India is unable to deny the entry of the yuan into the SDR basket, it must at least work hard to ensure its delay and/or extract commensurate quid pro quo from China in many other areas such as, but not limited to, ensuring that China leashes its lapdog as T.C.A. Srinivasa Raghavan put it recently in a column in Business Standard.

The Wall Street Journal discussed the benefits to India from China’s economic troubles. India should note that the benefits will also vanish if China’s economic troubles vanish. Put bluntly, the longer China’s economic troubles persist and the longer it takes for the Chinese currency to enter the SDR basket, the better it is for India.

V. Anantha Nageswaran is co-founder of Aavishkaar Venture Fund and Takshashila Institution.

Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go towww.livemint.com/baretalk

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