International pressure to revalue China’s currency stems in part from the expectation that rapid economic growth should be associated with an underlying real exchange rate appreciation. This hinges on the Balassa-Samuelson hypothesis, which sees growth as stemming from improvements in traded sector productivity and associated rises in wages and non-traded prices. Yet, despite extraordinary growth after the mid-1990s China’s real exchange rate showed no tendency to appreciate until after 2004. We use a dynamic general equilibrium model to simulate the economy and show that, during this period, trade reforms and a rising national saving rate were offsetting forces in the presence of elastic labour supply. We then examine the possible determinants of the striking transition to real appreciation thereafter, noting mounting evidence that an improved rural terms of trade has tightened China’s labour market. We show that, should the Chinese government bow to international pressure by appreciating the renminbi either via an extraordinary monetary contraction or via export disincentives the consequences would be harmful for both Chinese and global interests.
