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A Turning Point in China?s Economic Growth


This new policy on exchange rates will be remembered as a benchmark event, reflecting China's overall economic growth.

There have been many evaluations of the new exchange rate reform policy that consider the problem on the basis of short-term aspects, timely choices and political elements.  And while the short-term effects are surely important, the long-term significance should be equally emphasized.  The most important long-term effect of new exchange rate policy is that of supporting the Renminbi's trend of appreciation from the aspect of policy change.  This is a sign that China's economic growth has entered a period of a rising actual exchange rate.

Since reform began, the economy has continuously maintained a high rate of growth.  However, because of specific aspects of the path and environment of economic growth in China, the actual rate of exchange for the RMB did not initially have a tendency for appreciation.  The RMB went through a long period of depreciation only followed by a push toward appreciation.  In the years between the late 1970's and early 1990's, the nominal exchange rate of the RMB against the US dollar as well as a basket of other currencies depreciated between four and five times, while the actual exchange rate depreciated only two times.  Since the mid-1990's, following China's basic economic advances, the actual exchange rate of the RMB has gradually shown a trend toward appreciation in line with standard economic predictions.  Although the domestic economy later showed signs of deflation, after short-term effect of the above methods wore off, the trend toward appreciation has in recent years once again become a key element, affecting the overall functioning of the economy.  In this new environment, adjusting the pegged exchange rate to be responsive to external shock, making the actual exchange rate, a key price parameter, able to better act as an adjustor in the domestic and international economy, has become an overarching and pressing issue.  From this perspective, the determination of economists in recent years that “exchange rates are central, the rest will follow in rank” is not without reason.

Analysis of the Cause of Appreciation in the Actual Exchange Rate

Why, in the process of China's rapid economic growth, did the RMB's actual exchange rate move from depreciation to appreciation?  There are three main answers to this question:

First, there was a change in the relative growth of labor productivity in tradable industries.  Although China's economy has been growing rapidly since the beginning of reforms, to the most important producers of tradable goods, China's labor productivity in the 1980's could not be compared with many OECD countries, much less the United States.  There was no increase and even a slight decrease in productivity.  After entering the 1990's, labor productivity in manufacturing industries began to increase.  Especially since the late 1990's, labor productivity began to catch up.  Initial calculations reveal that between 1995 and 2003, compared with the United States and OECD countries, China's labor productivity accumulated relative growth of 1.2-1.5 times.  According to the Balassa Samuelson Effect, the relative growth of labor productivity in tradable industries one can derive the pressure for the RMB to appreciate.

Second, the state of equilibrium in China's balance of payments has seen changes.  China's balance of payments for the most 1970's and 80's saw a deficit in trade and current accounts and a surplus in capital accounts, mainly in the form of foreign loans accounting for inflow to capital accounts.  The continued lack of foreign exchange and the tight balance of payments forced the nominal exchange rate depreciate at a higher rate relative to inflation, which led to depreciation in the actual exchange rate.  Since the 1990's, following division of labor in international products and deepening of integration with the international economy, China's balance of payments has seen a substantive shift, slowly forming new structure in the form of a dual-surplus of current accounts and capital accounts as well as capital accounts showing foreign businesses investing directly.  The continued dual-surplus of China's balance of payments is seldom seen in economic development and at the same time serves a key function in facilitating the trend of appreciation in the actual exchange rate.

Third, the phased process of reform and opening gradually eroded the distortive effects of the planned economy.  During economic planning, China overestimated of the nominal exchange rate, enterprises lacked competitiveness and the economy was closed resulting in low productivity.  The distortive effect of the planned economy on the exchange rate and its close relationship to the trade structure comes out in two areas.  The first is that in the first ten years of reform, overlapping exchange structures like the internal settlement price and adjusted rate foreign exchange market show the official overestimation of the exchange rate.  The second is that China used invasive methods such as export subsidies, high tariffs and quotas to preserve the equilibrium of balance of payments.  Reform gradually lowered and did away with this type of distortion.  On the one hand, after going trough a difficult stretch of periodic reforms, a single exchange rate system was established in 1994, basically dissolving the overlapping and distortive effects.  In addition, through several policies for market opening, specifically concessions made in talks for entry to the WTO and GATT, gradually lowered tariff and non-tariff trade barriers, allowing China's current level of market openness to be higher than the average for developing countries.  Continued elimination of distortive policies in international economic practices has had a great effect on open economic growth, but at the same time invited pressure for depreciation.  But elimination of these distortive effects has also been helpful for the trend of appreciation in the actual exchange rate of the Renminbi.

When looking from the perspective of relative growth of labor productivity, change in the equilibrium of balance of payments as well as the unique aspects of the gradualist approach of reform and opening, the change from depreciation to appreciation of the RMB is in accordance with the growth patterns in the Chinese economy.  However, it needs to be pointed out that this trend toward appreciation is a long-term trend derived from basic economic growth patterns of the RMB's actual exchange rate.  It is not to say that the actual exchange rate will continue to increase unabated.  The future of the actual exchange rate of the RMB is not only affected by certain trends, but by complicated domestic and international factors and may go in different directions in the short-term.  In addition, an increase in the actual exchange rate does not equal an increase in the nominal exchange rate, because the actual exchange rate may increase with an increase in commodity prices.  However, economic evidence shows that an era of a floating exchange rates, changes in the nominal exchange rate are usually the most important explanation for changes in the actual exchange rate.

Facing the Challenges of Success

If one can say that a connection between basic factors in China's economic growth and a rise in the actual exchange rate of the RMB is a long-term trend, from the perspective of the overarching nature of the system and policy, a system with a flexible exchange rate market must be established to recognize and accommodate this objective need.  From this perspective, the new policy announced on July 21st has long-term and far reaching implications.  From the other side, if the old exchange rate system and level of parity were maintained for a long time, while at the same time using China's unique macro-economic methods to control the increase in relative cost, substantial economic growth may be harmed because of the requirement of raising the actual exchange rate could not be influenced by policy.  Just like a young person going through puberty might be restricted by a tight piece of clothing.

The new exchange rate policy can also help to relieve international political pressure as well as the pressure of economic imbalance due to of the rapid rise in China's trade surplus.  For the long-term, reform of exchange rate policies is helpful for encouraging enterprises to initiate production equipment upgrades by using market pricing methods as well as promote the growth of non-tradable service industries.  In this way, gradually upgrading China's production and trade structure and effectively implementing the government's strategy of rational development, gradual advances in reform for the marketization of the Renminbi is a positive step in the direction of the ultimate goal of full convertability.

Like other pricing structures, deepening marketization of the exchange rate system will bring new difficulties.  Basic economic theory shows us that a rise in the actual exchange rate of a currency is a sign of restrictive factors entering an economy.  The change in the exchange rate announced on the 21st was relatively small, so the restrictive effect may be limited.  However, when one considers the present state of China's macro-economy is in a sensitive period of periodic changes and shows signs of moving in a deflationary direction, enough attention needs to be paid to the short-term effect of related policy changes, especially avoiding the negative shock that adjustment of exchange rate policy and overlooking the state of the macro-economy could bring.  A rise in the exchange rate may be bad for low-end exports, expanding employment and adversely affect the speed and timetable of redirection of rural labor.  However, if one looks from a different perspective, these shocks and negative effects are problems that are derived from the substantive successes of China's economic development.  In the end, they should be able to find resolution in the process of open economic growth.

In the past 20 years, China's use of the reform and opening policy has taken the first step on the road to developing a modern economy that is uniquely Chinese.  The emergence of a tendency for a rise in the actual exchange rate of the RMB within the process of economic development, new measures taken toward exchange rate reform are a positive step toward long-term sustainable and coordinated economic growth.  This author believes that this new exchange rate policy is not only a milestone for the reform of the Renminbi exchange rate system, but it will be noted as a benchmark event reflecting China's overall economic growth.