The shocks that underlie China's comparatively rapid growth include gains in productivity, factor accumulation and policy reforms that increase allocative efficiency. The well-known Balassa-Samuelson hypothesis links productivity growth in tradable industries with real appreciations. Yet it relies heavily on the law of one price applying for tradable goods, against which there is now considerable evidence. In its absence, other growth shocks also affect the real exchange rate by influencing relative supply or demand for home product varieties. This paper investigates the preconditions for the Balassa-Samuelson hypothesis to predict a real appreciation in the Chinese case. It then quantifies the links between all growth shocks and the Chinese real exchange rate using a dynamic model of the global economy with open capital accounts and full demographic underpinnings to labour supply. The results suggest that financial capital inflows most affect the real exchange rate in the short term, while differential productivity is strong in the medium term. Contrary to expectation, in the long term demographic forces prove to be weak relative to changes in the skill composition of the labour force which enhance services sector performance and depreciate the real exchange rate.
. China's 'equilibrium' real effective exchange rate is explored using an adaptation of the Devarajan-Lewis-Robinson three-good general equilibrium model under a variety of assumptions about the balance of trade. The absence of secondary indices of import and export prices necessitates their construction from trade data. Some undervaluation is suggested in the lead-up to and during the financial crisis, due in part to an extraordinary accumulation of foreign reserves following exchange rate integration in 1994. If, instead, China had run a more typical trade balance prior to the crisis its real effective exchange rate would have been higher by about a tenth.
The Chinese government's de facto peg to the appreciating dollar in the latter half of the 1990s is said to have stabilised financial flows in the region during the Asian financial crisis.1 Yet the peg may have been associated with substantial undervaluation of the renminbi prior to and during the crisis, revaluations against Asian competitors notwithstanding.2 Although the suitability of the de facto peg was widely questioned, leading to the modest relaxation of *Correspondence, Professor Rod Tyers, School of Economics, College of Business and Economics, Bldg 25A, ANU, Canberra, ACT 0200, Australia. Email: rod.tyers@anu.edu.au. Thanks are due to Prema-Chandra Athukorala and Yongzheng Yang for useful discussions on the topic of this paper, to Gonca Okur from the World Bank for assistance in the calculation of import and export price indices, to one anonymous referee and to Associate Editor Leonard K. Cheng for valuable comments on the first draft. †The first draft of this paper was completed during Yongxiang Bu's studies at the Australian National University. He is presently Deputy Director of the Research Department at the People's Bank of China. The views expressed in this paper are those of the authors alone and in no way represent those of the People's Bank of China.
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