How cheap are Chinese goods : An analysis of the exchange rate regime in China

In December 1978 Deng Xiaoping announced a new path for the Chinese economy. The new strategy for China was to open up to the rest of the world and reform their domestic economy from a planned to market based economy. Three decades later China has become the second largest economy in the world, mainly through openness to international trade and their competitive exporting sector. The last decade China has been under pressure from their trading partners, mainly the United States, to revaluate their domestic currency, the RMB. This paper seeks to explore if China has managed to keep their export sector artificial competitive by keeping their currency undervalued and by the same time keeping a lock on domestic inflation. According to the Balassa-Samuelson effect, a country that increases its productivity relative to other countries tends to increase their relative price level. This thesis investigates this effect in China relative to 122 other countries over a time period of sixteen years to see if the prices on Chinese goods are artificial low in an international context. To analyse the empirical strength of the Balassa-Samuelson effect we run a regression using purchasing-power parity data for 123 countries over the time period from 1994 to 2009. The results of the analysis suggest that the Balassa-Samuelson effect is at work for the whole group as one, where 1 per cent higher GDP per capita gives 0.34 per cent higher prices. When we divide the sample we find that the effect is stronger for wealthier countries than for the poor. The effect among the poor group, which contain the 41 countries which had a GDP per capita lower than 10 per cent of that in the U.S. in 2009, is not significant different from zero. The group containing the wealthier nations identifies that 1 per cent higher GDP per capita gives 0.54 per cent higher prices. Chinas real exchange rate follows this pattern; there is no appreciation of the real exchange rate before 2005, when China would be categorized in the poor group. After 2005 when China has a GDP per capita above 10 per cent of that in the U.S., the effect is stronger than the model predicts is normal for the whole group. This thesis concludes that the fixed exchange rate in China has served them well in achieving price stability and good condition for international trade. But that the fixed exchange rate has been less suitable for China after 2005, China then entered a phase where strong economic growth have been coupled with appreciation of the real exchange rate, a trend that is likely to continue in the future. If China continues with a fixed exchange rate against the U.S. dollar in this scenario the domestic inflation will move the real exchange rate towards equilibrium in the long run. Signs of this evolution are already emerging where China has been under severe diplomatic pressure from the United States to let the RMB appreciate, while domestic inflation reached 5.4 in March. This thesis therefore argues that an appreciation of the RMB would help China gain price stability. We also suggest that a floating currency will be beneficial in acquiring a more sustainable economic growth path and reduce the risk for a future slowdown in the economic growth