Free Trade Area or yuan trap?

During the visit of Chinese President Hu Jintao last week, there was much loose talk (but no decision) regarding an India- China Free Trade Area (FTA). This is a terrible idea that must be aborted. The most important reason is that free trade with China will be illusory until it stops rigging its currency, the yuan.

This assertion may puzzle many readers: few of them will be aware of any connection between free trade and exchange rates. When two countries agree to form an FTA, they abolish all import duties on one another’s exports, to create a level playing field between domestic producers and importers in both countries. What, you may ask, do exchange rates have to do with it?

Quite a lot. I think China keeps the yuan underpriced by at least 15%. This makes all Chinese exports 15% cheaper, and all imports into China 15% more expensive, than would be the case with a realistic exchange rate. Such a rigged exchange rate destroys a level playing field for trade. In a bilateral FTA, China would, through exchange rate manipulation, be imposing a hidden tax of 15% on imports from India, while giving a hidden subsidy of 15% to its own exports to India.

Now, both China and India claim they to have marker-related exchange rates, not rigged ones. So, what is the proof that China has an undervalued currency and India does not? To find the answer, look at their respective balances of payments. A seriously underpriced currency should help create huge current account surpluses. Realistic currency pricing should produce a modest current account deficit in most developing countries.

The US has long claimed that China rigs it currency. But this was not entirely clear between 1994 and 2003, when China ran modest current account surpluses averaging $ 20 billion a year. It also enjoyed large capital inflows, which took its foreign exchange reserves to $ 346 billion by mid-2003.

But after 2003 China’s trade surpluses and forex reserves have soared so mightily that an underpriced yuan is clearly the main, though not sole, reason. China ran a current account surplus of $ 160 billion in 2005, and the World Bank estimates this will rise to a whopping $ 223 billion (or 8.5% of GDP) in 2006. China’s foreign exchange reserves are now the biggest in the world, crossing the once-unthinkable figure of one trillion dollars.

What about India? It ran substantial current account deficits through the 1990s. Then, thanks to a spurt in remittances from overseas Indians, it ran small surpluses totaling $ 18.8 billion in the three years from 2001-02 to 2003-04. But then the surplus turned into deficits of $ 5.4 billion and $ 10.6 billion in the next two years. So, India is not rigging the rupee to create huge trade surpluses.

That should settle the argument. China is rigging its currency, and India is not. So, instead of expressing pious hopes that bilateral trade will double by 2010 (as was the case during Hu’s visit), India should argue that currency rigging is a serious impediment to bilateral trade that needs to be tackled.

In any event, there are other good reasons to oppose an India-China FTA. Global tariff reductions by all countries under WTO will definitely give a fillip to world trade and competitiveness. But bilateral FTAs can result in trade diversion rather than trade creation. If Japan can supply a cheaper gadget than China, why should India buy this from China by giving it a tax break through an FTA?

Indeed, this is not even good for China. That country will gain the illusion that it is competitive in these gadgets when it is not, and second-rate gadget producers will become unwarranted captains of industry, with unwarranted influence on economic policy. The whole point of trade is to discourage uncompetitive enterprises, not reward them through preferential FTA access.

India has already gained much and can gain more by unilaterally reducing import duties on goods from all countries. But it should not reduce duties selectively for particular countries through FTAs. Politicians love FTAs since these are easy to negotiate. But many economists, notably Jagdish Bhagwati have long condemned proliferating FTAs in the last decade as a spaghetti bowl. Each spaghetti noodle has its own special rules and exemptions. So, instead of the clarity and simplicity of free trade, we get the mind-boggling complexity and confusion of a spaghetti bowl of rules.

Having different trade rules for China will create all sorts of hassles—and corruption opportunities—when clearing cargoes through customs. Inevitably, crooks will misdeclare goods from other countries as Chinese goods, and crooked customs officers will oblige. This will help neither China nor India.

The clinching argument remains the one about currency. Until China revalues its currency, signing an India-China FTA will mean walking into a yuan trap.

What do you think?