How to catch a falling knife

China faces two equally undesirable options due to rise in inflation
1. Raise interest rates and risk slowing down the economy.
2. Allow Yuan to rise and risk jobs.

     The problem is exacerbated due to rising consumption levels of an average Chinese citizen. Due to rising incomes, the first item that gets consumed more is food. The second would most likely be energy. Interestingly these two items are generally not included for calculation of inflation levels. And in the recent times, rise in price levels of these two items have hurt the consumer the most. Governments attribute the price rise to supply side issues. In common terms, supply side means production and demand side means consumption. Raising interests may increase the cost of hoarding but does nothing to improve supply. As china is a net importer of energy, a rising yuan will automatically reduce prices of imports and by extension, cost of imported energy. A rising yuan will thus help Chinese consumers to consume more at cheaper rates and imports would rise. China can afford increase in imports as it has a net trade surplus. The nature of chinese exports have changed over time and presently bulk of chinese exports are finished goods. Finished goods create jobs and gives more value addition. Lesson: China can afford import of raw materials, rising yuan will reduce input costs and thus make finished goods more competitive.

 Source: IMF

The same situation in the inflation front is faced by India but we do not have the comfort of trade surpluses.

However, in India's export basket engineering goods comprise of only 21.8% (source economic survey 2010-11). Bulk of our export basket consists of low value added products. We are also running consistent trade deficits but this effect has been mitigated to a great extent by export of software services and remittances of non resident Indians.

Where does that leave India?

The jobs easiest to shift back for USA are in the Service sector. And hence, one of the first casualties of recession in the developed world would be our jobs in those sectors. Shifting of jobs in manufacturing will be the most difficult because of the reasons I have discussed in an earlier post "Revenge of an Underpaid Chinese worker". Need for capital investment and achieving economy of scales will make this option harder for developed countries. Any move by India to allow rupee to rise would also impact margins in software services exports. The remittances of non resident indians will also fall in value with the rise of the rupee. However, if India opts for keeping rupee cheap, it runs the risk of importing inflation especially due to crude oil imports. We do not have suitable offsets like the Chinese Economy but we face similar 'supply side shortfalls'. The situation is tricky. Will our central bank choose to sail with the dollar (and risk inflation) or allow rupee to rise and risk losing growth momentum?