Jiandong Ju, Shanghai University of Finance and Economics; Justin Lin, World Bank; Qing Liu, Tsinghua University; and Kang Shi, Chinese University of Hong Kong

 A Dynamic Structural Analysis of Real Exchange Rate: Theory and Evidence from China

 

Since China joined the WTO in 2001, the Chinese economy has grown very rapidly, especially, the tradable goods sector. However, the Chinese real exchange rate did not exhibit a persistent and stable appreciation until 2005. This is a puzzling fact that is inconsistent with theories. This paper documents several stylized facts during the economic transition and argues that two features of the Chinese economy may help explain the puzzling real exchange rate pattern: i) the faster total factor productivity (TFP) growth in export sector compared with the import sector; ii) excess supply of unskilled labor. Ju, Lin, Liu, and Shi construct a small open economy model with an H-O trade structure and show that, due to heterogeneous skilled labor intensity in export and import sectors, the faster TFP growth in the export sector over that in the import sector will lead to the decline of return to capital and the rise of skilled wage. Therefore, the decrease of return to capital and the persistent low unskilled wage, which is caused by the excess supply of unskilled labor, inhibit the rise in the relative price of non-tradable goods to tradable goods as well as the appreciation of real exchange rate. Furtheremore, the researchers develop a dynamic small open economy model with multiple tradable goods sectors, and show that the model does fairly well in explaining the Chinese real exchange rate and other stylized facts in the economic transition. Finally, the authors demonstrate that their hypotheses are supported by cross-country evidence.