The beating of the drums have been heard again and this time its probably for real. The US seems to have successfully muscled through an appreciation of the Yuan despite Chinese attempts to pull the handbrake.  

The question remains, though, how much it will help the American economy? Not very much if experience is a judge. In 1985, Japan was forced to revalue the Yen (The Plaza Agreement), without much impact on the bilateral trade balance. The 1985 a deficit of USD 46 bn rose to around USD 50 bn in both 1988 and 1989, after which it fell slightly.

The Plaza Agreement was neither a bilateral US-Japan exercise nor confined to currency rates. It was a broad agreement aimed at realigning the economic policies of the major powers. Apart from currency rate changes, the US promised to cut its budget deficit (in 1985 at USD 212 bn), Japan promised to maintain a loose monetary policy and Germany promised to introduce tax cuts. Great Britain and France also pledged changes in their economic policy. Even if events proved that these undertakings did not work as intended, they expose the need for a concerted effort among the leading economic powers beyond currency rates. Such an approach is sorely needed at the present junction, and as far as can be seen, it remains absent from the agenda of the leading policy makers. The 21 per cent appreciation of the Yuan from 2005 to 2008 clearly shows that it is an illusion to count solely on exchange rate changes.
 
The main counterargument is that the problem has little to do with China or US competitiveness, but is rooted in the fundamental dis-saving complex that has been harassing the American economy for more than a decade. Only by bringing consumption in line with production can the US revert the balance leaving the Yuan largely irrelevant in this context. If the US is prone to overspending, a Yuan appreciation may cut imports from China, but shift it to other low cost producers primarily in Asia, but possible also in Latin America. This is why China, with some justification suspects that the whole show has more to do with stopping China in its tracks than doing something for production and employment in the US. The Yen appreciation in 1985 (it rose almost 50 per cent vis-à-vis the USD in two years) was regarded as a contributing factor in wrong footing the Japanese economy, thus laying the ground for the Japanese domestic melt down which begun in 1990.
 
Irrespective of these arguments for and against, more interesting questions remains largely unaddressed: what will an appreciation of the Yuan mean for the supply chain in Asia? Or in other words if the Chinese exports to the US start to fall, how much will other Asian countries that deliver intermediate products to China for final export to the US suffer? According to analysis by the Asian Development Bank (ADB) the supply chain has gradually strengthened in Asia leading to a vertical integration of production with the final output destined for a final demand destination outside the region.
 
Figures show that 43 per cent of Asia’s exports go to the G-3 (US, Europe, and Japan), but if the supply chain is incorporated in the analysis, the figure rises to more than 61 per cent as 70 per cent of intra-Asia trade consists of intermediate goods. Not surprisingly, China is at the centre of the supply chain. And not surprisingly this leads to the conclusion that if Chinese exports to the US are hit, so are imports into China of intermediate goods from the rest of Asia with negative consequences for a large number of Asian countries. Without doubt, there is a strong correlation between China’s exports to G-3 and China’s import from Asia.
 
The ADB report quoted as an example that in 1992, 15.5 per cent of China’s exports consisted of machinery and transportation equipment, but this rose to 46.2 per cent in 2006. At the same time their share of China’s total non-oil imports increased from 39.7 per cent to 48.4 per cent.
 
A similar picture unfolds with foreign direct investment (FDI).  FDI to most other regions in the world serve to produce for the home market. In Asia, however, FDI serves as a vehicle for building supply chains turning final products out for export primarily to G-3. The implication of this observation is that if exports from China are hit, FDI not only to that country, but to the main suppliers of intermediate goods will likewise suffer. The end producer (China in most cases) cannot be isolated or separated from the other participants in the chain. Over the last decade or so, the main source of FDI into the People’s Republic of China has come from Asia – a phenomenon that only buttresses the preceding point.
 
The US policy posture does not appear to have absorbed the state of affairs with China as Asia’s main centre for intra-firm and intra-trade acting not as an isolated unit, but as an integral part of a sophisticated network, where one part cannot be cut off from the others.
 
There are obvious lessons for Asia to learn, too. The most important one being that such an elaborate supply chain calls for an institutional framework to ensure that goods, services, and capital can flow freely. So far, membership of the World Trade Organization (WTO) has provided that, but there is no guarantee that this will continue to be the case especially if the main centre is hurt by outside forces as will be the case with a forced Yuan appreciation.
 
All the participants in the supply chain share a common interest in not only keeping the flows free from mutual trade restrictions, but to defend the whole supply chain from external pressure. This points to a stronger and deeper Asian integration, which keeps the trade and capital flows free from restrictions while serving as the vehicle for a common stance to fend off attacks from trade partners.
 
If such integration is not forthcoming, there is a risk that Asia’s main trading partners will play divide and rule hand, singling out one of the links in the supply chain and gambling upon the unwillingness of Asia’s partners to step in and defend their common interests. Without such a bulwark, the entire Asian economy remains fragile to deliberate policy actions like a forced Yuan appreciation or unexpected fluctuations in the global business cycle. Asia may lose its edge as the upcoming global powerhouse and its supply chain network unequivocally indicates that it is not really about one country, China – but about Asia as a whole.