China s Real Exchange Rate Puzzle

China s Real Exchange Rate Puzzle

International pressure to revalue China`s currency stems in part from the expectation that rapid economic growth should be associated with a real exchange rate appreciation. This hinges on the Balassa-Samuelson hypothesis under which economic growth is due to relative tradable productivity gains which cause rising relative non-traded prices. The puzzle is that, while evidence on China`s productivity and prices supports this hypothesis, its real exchange rate showed no tendency to appreciate during 1990-2006. Resolution requires allowance for failures of the law of one price for traded goods, which expands the array of determinants to include labour supply growth and demand switches due to changes in investment interest premia, saving rates and trade distortions. The sensitivity of China`s real exchange rate to these determinants is reviewed with the results confirming that financial outflows have been prominent depreciating forces since 1997. These, along with WTO accession trade reforms, have more than offset the Balassa-Samuelson productivity effects.