China's Economic Growth and its Real Exchange Rate

Abstract

The recent influx of financial capital to China implies expectations of continued real appreciation and, indeed, rapid expansion had previously led to real appreciations elsewhere in East Asia. 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 shocks are restricted to traded sectors. China is a special case amongst developing countries in that its labour force is likely to decline in future and this will place upward pressure on real wages and its real exchange rate. This paper assesses the magnitudes of the various links between China’s growth performance and its real exchange rate using an adaptation of the GTAP-Dynamic global economic model in which a full demographic sub-model is incorporated. A baseline “business as usual” simulation is constructed to 2030, wherein China’s growth rate slows considerably due to ageing and slower labour force growth. Comparator simulations are then constructed for cases in which fertility policy is changed, sectoral factor productivity is higher and financial reform reduces the investment interest premium. China’s real exchange rate realignments are examined in each case, the results suggesting the current appreciating trend may be temporary, with depreciating forces appearing to dominate in the long term.