Rod Tyers Illustrates China's Real Exchange Rate Puzzle at CCER
Apr 18-2013
By Victor Hu
Prof. Rod Tyers, an exchange rate expert from Australian National University, shared his thoughts on China’s real exchange rate puzzle with Beijing International MBA (BiMBA) students when he delivered a speech at CCER, Peking University on the afternoon of Nov 7th, 2007.
Prof. Tyers started his speech from the famous Balassa-Samuelson hypothesis. It has been argued that the appreciation of the RMB since 2005 is just the beginning of a necessary upward trend, given the belief that the currency is currently undervalued. The expectations that China’s underlying real exchange rate will appreciate in the future are commonly based on the Balassa–Samuelson hypothesis. The hypothesis implies a positive relationship between economic growth and the real exchange rate, driven by productivity catch-up in developing countries’ tradable sectors and, in association, rising prices in their non-traded sectors, and in turn, the appreciating real exchange rate.
As Prof. Tyers has observed, while evidence on China’s productivity and prices supports this hypothesis, its real exchange rate has shown no long run tendency to appreciate, which presents a puzzle. “What it predicts, why China’s real exchange rate did not go with the prediction and why it was the way we observe? ” Prof. Tyers raised the questions at the beginning of the lecture.
To resolve the puzzle requires the generalization of the assumptions on which the Balassa-Samuelson hypothesis is based. Prof. Tyers suspect the key assumptions of the hypothesis and offers a critique of tradable productivity gap, the law of one price for tradable goods, labor arbitrage and closed capital account. The generalizations greatly broaden the set of determinants of the real exchange rate. With these generalisations, almost all shocks to the economy have implications for the real exchange rate.
To examine these forces, a dynamic model of the global economy is used to construct a baseline business-as-usual simulation to 2030. The principal determinants of China’s economic growth are then shocked separately and their independent effects on the real exchange rate observed over time.
According to Prof. Tyers’ studies, in the short term, the key determinant is net financial capital influx, which appreciates the real exchange rate, or efflux, which depreciates it. In the medium term, scope does emerge for Balassa-Samuelson real appreciation, if services lag sufficiently behind industrial productivity. In the long term, however, if services remain relatively skill intensive on average, their performance will be bolstered by both direct productivity improvements and skill acquisition, and the result will be a substantial depreciating force.
There are numerous other forces tending to depreciate the real exchange rate in the long term. Prof. Tyers named China’s ‘demographic dividend’ during the past two decades as one example. The high proportion of working-aged people in the total population has played a critical role in keeping wages and hence the real exchange rate low, thereby enabling the rapid expansion of labour-intensive manufactured exports. In the future, however, the ageing of the population and the consequent decline in the labour supply will have the opposite effect, placing upward pressure on real wages and the real exchange rate.
“There is no doubt that the Balassa-Samuelson appreciating force has been in action in China. Our generalizations of their hypothesis allow consideration of countervailing forces.” Prof. Tyers emphasized that these countervailing forces must have prevented any significant real appreciation between the early 1990s and 2006.
In the long term, since Chinese productivity growth has been higher than that of its trading partners for more than a decade, and considerable scope remains for productivity catch-up in services, the latter could bear down on the real exchange rate. It is difficult to ignore the fact that the majority of the growth-related shocks examined—including overall (and particularly services) productivity growth, professional training and further trade reform—all cause the real exchange rate to depreciate in the long term. Yet, whichever productivity pattern dominates, the future path of the real exchange rate will also depend heavily on financial flows and hence on China’s domestic savings relative to its investment. Eventually, its saving rate must fall. When it does, net flows on the capital account will be reversed, resulting in a strong appreciating force. The long-term outcome will then depend on the extent to which this force is offset by continued skill acquisition and services productivity growth.
At the end of the speech, Prof. Tyers listed some still unresolved puzzles. They are the high saving rate, the effect of relaxing capital controls, the effect of the montary merchantism and the effect of “pre-mature” or “too-fast” appreciation.
Prof. Wu Ho-Mou from CCER presided over the lecture and Prof. Lu Feng from CCER made further comments on Prof. Tyers’ speech.
“I had nice discussions with Prof. Tyers on this topic last year which made me think more and deeper on this.” Prof. Lu Feng who also published papers on the same topic thought high of Prof. Tyers’ speech. He said, Prof. Tyers’ work presents a comparison with the existing studies in this area, takes the BSH seriously and has designed several parameters with the modeling works while combining with the macro-saving perspectives. Prof. Lu believes that the global model in Prof. Tyers’ paper provides a handy framework for assessing impact of various structural variables on real exchange rate.
“His work presents the special value of ‘Australian School of the Chinese Economic Studies”, Prof. Lu added, referring to a group pf economists in Australia who follow several key issue in China’s economy.
Prof. Lu also shares his understanding of China’s real exchange rate through an evolving pattern and the conceptual definition for equilibrium real exchange rate. He presents a working assumption about the equilibrium with RER (real exchange rate), BOP (balance of payment) and FER (foreign exchange reserve). He proposed the “double relative productivity” or “relative relative productivity”, which is a “structure productivity”, to understand the Balassa-Samuelson hypothesis and interpret the real exchange rate for “a super-large economy during the process of rapid catch-up”. He emphasized the surging foreign exchange reserve other than Prof. Tyers “saving approach” in his explanation.
Trained originally in engineering at the University of Melbourne, Professor Tyers made the transition to economics and completed his doctorate at Harvard University in 1978. His research in international economics has emphasized economy-wide analysis and he has addressed issues including commodity market stability, technical change, demography, trade policy reform and macroeconomic policy as it affects exchange rates.
In 2006 and 2007, Prof. Rod Tyers has published several works on China’s real exchange rate together with Jane Golley and Iain Bain from College of Business and Economics at Australian National University and Bu Yongxiang from People’s Bank of China. The researches include “China’s equilibrium real exchange rate: a counterfactual analysis", "China's economic growth and its real exchange rate", "China's real exchange rate", "China's real exchange rate puzzle" and "Appreciating the renminbi".
