China and global rebalancing (the Lewis Model and Balassa-Samuelson)

In the first year of any macro course a key emphasis is the fact that real variables matter. Nominal variables are what you see quoted — and usually reported. So, for example, when you read that the euro has fallen to 1.20 dollars, that’s the nominal exchange rate. The real exchange rate is this nominal rate with the important adjustment of inflation at home and abroad. If two currencies trade at a stable rate for a couple of years but country A has twice the inflation of country B, then country A becomes a lot more expensive relative to B (even though the quoted exchange rate hasn’t budged). It has undergone a real appreciation. (You can download real exchange rate time-series from the Bank for International Settlements.)

Differences in inflation are often minimal, so most of the action in real exchange rates is simply the movement in nominal exchange rates. Where the nominal exchange rate doesn’t matter — can’t matter — is when the exchange rate is pegged. Which brings us to China. The United States has been desperate for China to command by government diktat a rise in the real exchange rate of the renminbi. This was always unlikely, because the real exchange rate would adjust to underlying factors regardless of changes to the nominal exchange rate. Had China acquiesced in a revaluation, then Chinese domestic prices would have responded with a decline.

What changes this is the rise in Chinese wages, which will generate broader inflation in China and therefore a rise in the renminbi’s real exchange rate. The source of Chinese wage rises is the traded-goods sector. Chinese workers are aware that their wage should equal the marginal product of their labour, and now they’re able to demand it due to the changing demographic profile in the country. High productivity growth in the traded sector brings up the wages. Since other sectors of the economy must compete with the traded sector for the same pool of labour, those higher wages are spread across the traded and non-traded sectors (the high-productivity and low-productivity sectors). Non-traded sectors are not priced internationally (their output is not tradable), so these prices will rise in order to pay for the more expensive labour. That’s the Balassa-Samuelson effect, which explains the real currency appreciation we see as countries develop.

This development is bullish for China and for the world economy. It could not have come at a better time. The problem facing the global economy today is a massive shortfall in demand. As China’s currency appreciates in real terms, its non-traded sector absorbs more resources, and the Chinese economy will see much higher rates of import growth. The world economy is not a zero-sum game (1/); China’s improvement in living standards is not made at someone else’s expense. Rather, it is a boost to the world economy. It not only means more demand for our output, but it will also migrate more jobs to poorer neighbours as the Chinese economy moves up the value chain.

Counter-intuitive though it might seem, this is also good for the environment, if you believe in an environmental Kuznets curve.

What’s happening in China in some respects reflects the predictions of the Lewis Model of industrial growth, where wage growth lags productivity growth because the industrial sector can draw labour from the agricultural sector. Once that source begins to dry, wage growth can take off. The result is rising inequality in the initial stages of industrialization (since more of the profits accrue to capital, i.e. the owners of production) and then falling inequality as labour demands a greater share of profits through rising wages.

We’ve been here before and it’s name is Germany. Fortunately, the economist Oliver Grant has written a masterful survey of this process in Germany during the last decades of the first modern age of globalisation, roughly 1870-1913 (2/):

The analysis contained in the preceding chapters has provided ample evidence of the existence of labour surplus conditions in Germany in the late nineteenth century…. High levels of rural-urban migration provided the motor for rapid economic growth….

No other European country had such a rapid transition to an urban industrial society. The rate of growth of the major cities was unusually high; the numbers migrating internally was also above the levels in other countries….

As a late-industrializing country, with a massive need to import food and raw materials, Germany had to expand exports rapidly, gaining share at the expense of other countries. This meant that wages had to be kept down….

The implications of the labour surplus period are set out in the propositions of the Lewis Model: growth will be high as under-employed labour is transferred to productive occupations; wages will tend to lag behind productivity in the advanced or industrial secgtor; the profits share will rise; the benefits of industrialization will go disproportionately to the owners of capital. Inequality in the urban sector will be high and remain so until the labour surplus phase is over, when the ‘turning point’ is reached. 

I would not be surprised if the Chinese leadership decide to get ahead of events by endorsing higher wages or limited collective-bargaining rights or something of the kind. They will also face the choice of higher inflation or a revaluation in the peg. I would guess they’ll opt for the latter. When people tell you that higher productivity growth will offset the wage growth (by keeping unit labour costs in check), remember Balassa-Samuelson. Yes, Chinese industry will still be competitive, and it will enjoy rising productivity growth. But a higher marginal product of labour means higher wages, and these will be shared in lower-productivity sectors in the non-traded economy, which means rising output prices i.e. inflation.


1/  The temptation to see growth as zero-sum is greatest in regard to natural resources. This oversight claimed even J.M. Keynes, whose otherwise thoughtful insights are so important today notwithstanding the global outbreak of economic puritanism. Writing on the eve of World War One, Keynes opined that the fantastic growth of the first modern globalisation could not be sustained, and that resource constraints would soon bind, bringing a decline in the standard of living. In fact, agricultural resources (to which Keynes referred) were on the verge of finding vast new acreages for development. I might reproduce his exact words later.

2/ Grant, O., Migration and Inequality in Germany, 1870-1913 (Oxford, 2005), pp 293-294.

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One Response to China and global rebalancing (the Lewis Model and Balassa-Samuelson)

  1. Very interesting post. Good blog.

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