What is a currency revaluation? --------------------------------------------------------------------------------
NEW DELHI/MUMBAI, India, Jul 22, 2005 (The Economic Times - Knight Ridder/Tribune Business News via COMTEX) -- On Thursday, China announced a revaluation of its currency, marking a 2.1 percent appreciation of the yuan which had been pegged to the US dollar at 8.28. So what really is revaluation of a currency? Why do countries engage in such an exercise? A country's exchange rate system can either be fixed or based on a floating rate system where demand and supply factors drive the value of the currency up or down.
In a fixed exchange rate system, the value of a country's currency is fixed relative to a hard currency, say the dollar. This system was in vogue in the '40s and '50s, following the Bretton Woods conference when it was decided to put in place this system to ensure a stable global economic scenario. Later, in the early '70s, developed countries shifted to a floating rate system.
When countries revalue their currency -- that is effect an upward change in the currency's value -- there are implications on both the capital and the current account. On the current account, imports become cheaper (where revaluation has been undertaken) and exports become more expensive. Cheaper imports will lower the cost of imported raw materials, and overtime, even wages, which would allow exports to be priced lower.
To what extent this happens depends on factors ranging from the import intensity of exports and productivity changes effected by the exporter. The effect on the capital account is for speculative investments to immediately unwind in the revaluing currency. Dollars could flow from China to the yen, and other emerging Asian markets, strengthening their currencies.
The longer-term anti-inflationary impact of a revaluation (via cheaper imports) make for lower interest rates. From a monetary point of view, this would induce an outflow of resources from China to those currencies whose interest rate differential vis-a-vis Chinese rates has gone up.
Lower interest rates could spur investment and attract more FDI, attracting inflows and reinforcing the currency's tendency to harden. In the case of China, it has been under pressure especially from the US to revalue, given the huge trade deficit of $162bn, which the US runs with Beijing. Yuan appreciation will mean that Chinese firms could lose their competitive edge and may have to brace for lower margins.
This is because the currency will be more expensive. India has had experience with the fixed rate. The rupee was pegged to the pound until the early '70s. In the mid-'70s after the first of the oil shocks, the rupee was pegged to a basket of currencies.
In '92-93, the country moved to a new system christened the liberalised exchange rate management system. Under this, 40 percent of the receipts or remittances of exporters were convertible at a fixed rate while the rest was convertible at the market rate. This dual exchange rate system was then given up and the country moved to fully managed float by '94.