China's rapid growth and real exchange rate appreciation: Measuring the Balassa-Samuelson effect

The real exchange rate of the Chinese yuan vis-à-vis the U.S. dollar appreciated by 4.6% per year from 2005 to 2015 after a period of stability (1996-2004). The fast appreciation may appear to be a classic case of the Balassa-Samuelson effect. China during this period was on a path of manufacturing-led rapid growth and technological catch-up. As expected, there was a large difference in total factor productivity growth between the tradable and nontradable sectors, which contributed to real exchange rate appreciation. However, a decomposition of the annual 4.6% real exchange rate appreciation reveals that the magnitude of the Balassa-Samuelson effect was relatively small at 1.2 percentage points. The more important factor was real appreciation in the price of tradables (a rise in the price of China's tradables relative to U.S. tradables) at 4.4 percentage points. This pattern-a modest Balassa-Samuelson effect and a large real appreciation in the price of tradables-was also present in Japan and Central and Eastern European transition economies, all of which experienced long-term real exchange rate appreciation during their high growth periods. China's recent case adds to evidence that the magnitude of the Balassa-Samuelson effect is usually modest and does not account for the bulk of observed rapid real exchange rate appreciation in high growth economies.