Sunday, 16 October 2011

Real versus nominal

In this case its real versus nominal exchange rates. Much has been written about China’s currency manipulation policies and why its bad policy. But most of the anti-Chinese rhetoric has been written as if its the nominal exchange rate that’s important. But what’s happening to the real rate?

At his blog economist Ed Dolan looks at this issue. He writes,
[...] what really matters for US-China competitiveness is not the nominal exchange rate, but the real exchange rate. The simplest way to calculate the rate of real appreciation of the yuan against the dollar is to add the inflation differential between the two countries to the rate of nominal appreciation. Recently, inflation in China has been running about 3 percentage points higher than in the United States, depending on what price index you apply. That implies a rate of real appreciation of about 8 percent per year. Such a rate is enough to wipe out a 20 percent undervaluation in less than 3 years or a 40 percent undervaluation in less than 5 years. That’s change you can start to believe in.

There’s more to the story than that, however. What really matters for jobs and competitiveness is not consumer price inflation, but the rate of change of unit labor costs. (Unit labor costs are wage rates adjusted for changes in productivity.) A recent study from the Boston Consulting Group suggests that Chinese unit labor costs will grow at about 8.5 percent per year over the next five years. Meanwhile, U.S. unit labor costs in manufacturing, where the head-to-head competition for jobs lies, have been on a steady downward trend, because productivity growth has been strong and wage increases moderate. The most recent data, which show a tiny upturn, are the first increase in 10 quarters.

Conservatively speaking, then, it appears that over the past couple of years, the real exchange rate of the yuan, deflated by unit labor costs, has been appreciating against the dollar at a rate of something like 15 percent per year. Even if the U.S. unit labor cost trend flattens out, a continued 10 percent rate of appreciation appears likely.

Let’s remember that back in the spring of 2010, when the Chinese were still holding firm to their peg of 6.82 yuan to the dollar, the maximum demand being made by American China-bashers was a 40 percent revaluation. In the fifteen months have elapsed since the peg was abandoned, a third, maybe even half, of the gap has vanished. At the rate things are going, the yuan will reach parity against the dollar, measured by unit labor costs, about two years from now, possibly sooner.
So lets keep it real.

Given all of this, What are we to make of the recent U.S. moves to counter the Chinese manipulation of its currency?
The bottom line? The Senate’s latest assault on Chinese currency manipulation makes no sense at all. Its economic goals will already have been reached long before the tortured procedures it calls for could ever work themselves out. The bill is a blatant play for ephemeral domestic political gain at the risk of unneeded diplomatic conflict. We can only hope that the legislation will die in the House, or if it passes there, that it will be vetoed by the White House, and if so, that any attempted override falls short. Thank goodness for checks and balances.
In other words the politicians make no real sense, again.

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