China's Economic Growth and its Real Exchange Rate

Pressure from abroad to revalue China’s currency appears to associate its rapid economic growth with the likelihood of a real appreciation. In a world of open economies and differentiated traded goods, however, development-related productivity and endowment growth shocks tend to cause real depreciations, the principal exception being the Balassa case where non-traded service sectors are large and productivity growth is considerably faster in traded sectors. Yet China is special amongst developing countries because its labour force is likely to decline in future and this will cause upward pressure on its real exchange rate. This paper quantifies the links between 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, in the short run, the dominant force is financial capital inflows, which are appreciating. In the long run demographic forces prove to be weak relative to skill transformation and services sector productivity. These are both comparatively powerful and depreciating. While financial capital inflows driven by expected appreciation may be self-fulfilling in the short run, these results suggest that the fundamental forces are more likely to favour a trend toward real depreciation.