China’s Exchange Rate Trap: Japan Redux?
Scandinavian Model of Wage Adjustment= When currencies are pegged to a higher currency
their productivity growth will soar. (Examples, Scandinavian countries in the postwar era as well
as Japan in the same era).
The key is to ensure that monetary and exchange rate conditions are right so that high wage
growth accurately reflects productivity gains.
China’s fixed exchange rate coupled with more openness ended the “roller coaster” ride in
China’s domestic inflation.
Fixing the nominal exchange rate also helped increase Chinese GDP after 1996 since it
provided a much more needed nominal anchor when very rapid financial transformation
made purely domestic monetary control mechanisms difficult to implement.
However, in order to preserve this anchor, manufacturing wages had to increase and they did.
This has left companies betting on what the future wage rate will be (if it will continue to increase
or not). This has created a negative risk premium= if they guess wrong they will be paying more
than they should for labor.
This negative risk premium would be a serious problem if the exchange rate moved erratically.
If China were to suddenly float its exchange rate it could create a zero-interest liquidity trap in
financial markets that leaves the Central Bank helpless to fight future deflation that would arise
The only problem to this would be to peg the Yuan for the foreseeable future.
Making Room for China in the World Economy
o Rodrik makes the argument that achieving macroeconomic stability is possible with an
appreciation of the RMB if there is further institutional support for tradable goods in
o China needs to replace foreign demand with domestic demand.
o It is better to support tradable goods directly through subsidies than indirectly through
Promote Tradables if you want Growth
o A move towards high tech goods in China will help close the gap between manufactured
goods in developed countries and in China.
o Industrial activity can be underprovided in China if:
1. Institutional weaknesses exist (i.e. poor protection of property rights)
2. Market failures and externalities
o Currency undervaluation has enabled the Chinese economy to artificially boost the
profitability of manufactured exports.
o However undervaluation also acts as a tax on domestic consumption of tradables.
China and Currency Undervaluation
o Rodrik believes that since entrance to the WTO China has been unable to promote
tradables using its conventional methods and has thus resorted to undervaluation. o Unfortunately China is still a poor nation and appreciating its currency would certainly
slow down its GDP growth rate. Something they don’t want to do.
Is the Key the Trade Surplus, Exports, or the Production of Tradables?
o The “spillovers-from-exporting” story relies on the technological or marketing
externalities that occur when goods cross a border.
o The “tradables-are-special” story is indifferent to whether international trade has occurred
o In the regression analysis that Rodrik does the following becomes clear
1. Trade surpluses exert no additional positive effect on economic growth
2. The industry variable is highly significant
3. The coefficient on the exports is low if not negative
o Neither exports nor trade surpluses are key as long as domestic demand for tradables
can be increased alongside domestic demand.
Structural Change and Growth without Trade Surpluses
o Fast growth happens when there is rapid structural transformation from low-productivity
traditional sectors to high-productivity modern activities
o However market failures and institutional shortcomings prevent this from occurring.
o You can subsidize tra