DOES A STRONG ECONOMY CREATE A STRONG CURRENCY?(II)
Contrary to the B-S effect, China's economic growth didn't result in appreciation of the real exchange rate of the RMB. During 1979-2000, the average annual economic growth rate of China registered 8.2%, 6.1 percentage points above that of the US, while the average annual depreciation of the RMB against the USD posted 5.7%.
If we look into the annual economic growth and change in the real exchange rate year by year, we find that with the increase of China’s economic growth, the RMB real exchange rate experienced depreciation followed by appreciation.
Until 1994, there had existed a negative correlation between China's economic growth and the RMB real exchange rate. Starting from 1995, the correlation between the two turned to positive.
Why did the RMB real exchange rate move in such a pattern with the increase of the economic growth? In 1978, China began the transition from a closed economy to an open one. The RMB was then over-valued. Large current account deficits did not occur only because of high tariffs, stringent trade restrictions and capital controls. In the initial period of the opening up, to eliminate import barriers and promote exports, China had to correct the over-valued RMB exchange rate. The decrease of the RMB nominal exhchange rate was larger than the difference between the Chinese and US inflation rates, hence there was a drastic decrease in the real exchange rate. The continuous depreciation of the RMB real exchange rate was assumed to be a precondition for the growth of the economy. After China had enjoyed sustained and rapid economic growth, its economic strength accumulated to such an extent that the RMB real exchange rate began to show trend of appreciation.
The change in the RMB exchange rate in 1994, however, was not simply an adjustment of the currency value, rather, it was an institutional transformation. Starting from 1994, all forex supply and demand has been brought into the market, and the RMB exchange rate has been determined largely by market supply and demand.
The relationship between the change of the RMB real exchange rate and China's relative economic growth experienced fundamental change after 1994. It can be inferred that the sharp depreciation of the RMB nominal exchange rate was the superficial reason for the change, while the significant transformation of the China's forex administration regime and the RMB exchange rate regime were the deeper ones. In 1994 a series of reform measures in finance, foreign trade, fiscal policy and taxation also influenced this effect. Additionally, in the 16 years between China's reform and opening up and 1994, the Chinese economy maintained sustained and rapid growth, great changes took place in economic structure, and a socialist market economy took initial shape. All these may be the deep-root causes for the change in the relationship between the two factors.
Can the B-S theory explain the positive correlation between China's economic growth rates and the change of the RMB real exchange rates after 1994? This article suggests that the answer is no.
During 1995-2000,with the RMB nominal exchange rate remaining basically stable, the change of the RMB real exchange rate was mainly dependent on price changes in China. If the Chinese price level rose, the RMB real exchange rate appreciated; if the price level went down, the rate depreciated. The change of China's price level in recent years received its initial impact from private investment. The main factor causing deflation to persist and worsen rests in the decrease of consumption demand from residents rather than hinging on the change of relative tradables-nontradables price caused by productivity change in the trade sector. Regarding the current situation in China, it is the demand side rather than the supply side that determines the change of prices, and hence that of the RMB real exchange rate.
It should be noted that the B-S effect may exist in China in the future. The reasons are as follows. Firstly, industries in China are advancing and the increase in exports will shift from labor-intensive industries to technology- and capital-intensive industries. The productivity of the trade sector will improve immensely. Secondly, if surplus rural labor is absorbed by the industrial sector, improvement of productivity in the trade sector will push overall wages to rise, and in turn force the real exchange rate to appreciate. Thirdly, with China's accession into the WTO and the development of an outward-oriented economy, China will gradually release various restrictions and controls. The adjustment of prices and the exchange rate will reflect more of the inherent market demand.
(by Shao Jie, SAFE)