Accepted Manuscript

Title: China’s Rapid Growth and Real Exchange Rate

Appreciation: Measuring the Balassa-Samuelson Effect

Author: Hiroyuki Imai

PII: S1049-0078(17)30027-1
DOI: https://doi.org/10.1016/j.asieco.2017.12.002
Reference: ASIECO 1080

To appear in: ASIECO

Received date: 9-2-2017

Revised date: 17-11-2017
Accepted date: 4-12-2017

Please cite this article as: & Imai, Hiroyuki., China’s Rapid Growth and Real
Exchange Rate Appreciation: Measuring the Balassa-Samuelson Effect.Journal of
Asian Economics https://doi.org/10.1016/j.asieco.2017.12.002

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 China’s Rapid Growth and Real Exchange Rate Appreciation:
Measuring the Balassa-Samuelson Effect
Hiroyuki Imai

Department of Finance

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Carlson School of Management
University of Minnesota
321-19th Avenue South

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Minneapolis, MN 55455
Email: himai@umn.edu
Tel. 612-624-2888

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November 2017

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China’s Rapid Growth and Real Exchange Rate Appreciation: Measuring the Balassa-Samuelson Effect

Abstract

The real exchange rate of the Chinese yuan vis-à-vis the U.S. dollar appreciated by 4.6 percent per year

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from 2005 to 2015 after a period of stability (1996-2004). The fast appreciation may appear to be a classic

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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

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growth between the tradable and nontradable sectors, which contributed to real exchange rate

appreciation. However, a decomposition of the annual 4.6 percent real exchange rate appreciation reveals

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that the magnitude of the Balassa-Samuelson effect was relatively small at 1.2 percentage points. The
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more important factor was real appreciation in the price of tradables (a rise in the price of China’s
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tradables relative to U.S. tradables) at 4.4 percentage points. This pattern―a modest Balassa-Samuelson
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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
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appreciation during their high growth periods. China’s recent case adds to evidence that the magnitude of
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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.

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JEL classification: E31, F31, O47, O53

Keywords: real exchange rate, purchasing power parity, the Balassa-Samuelson effect.
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1. Introduction

On January 1, 1994, the Chinese government unified the exchange rate by devaluing the official

rate (5.8 yuan per U.S. dollar) to the prevailing parallel market rate. A single exchange rate was

established at 8.7 yuan per U.S. dollar, and the People’s Bank of China began defending the rate through

official intervention in the newly-opened interbank market. After making incremental rate adjustments,

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the bank in 1995 adopted a fixed rate of 8.3 yuan per U.S. dollar. The rate lasted for a decade until July

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2005 when the bank revalued the yuan by 2 percent against the U.S. dollar and replaced the fixed rate by

a managed float to open the way for the yuan’s gradual appreciation. The yuan’s slow continual

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appreciation lasted until August 2015. The strengthening U.S. dollar vis-à-vis major currencies forced the

People’s Bank to reverse its policy that month and the yuan depreciated gradually against the U.S. dollar

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thereafter.
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The 1994 exchange rate unification, which was part of the broad reform-cum-retrenchment
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program, had two objectives. First, a fixed exchange rate was instrumental to countering acute
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inflationary pressures during the investment-led boom in the first half of the 1990s. Second, the Chinese

government was anxious to promote exports. Having established a single exchange rate, the government
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gradually lifted exchange controls on current account transactions over several years. The two policy
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goals were fully met. Exchange-rate based stabilization was successful, and the rate of inflation, which

peaked in 1994 at 20.6 percent (GDP deflator), dropped by 1997 to 1.6 percent. China emerged as a
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strong manufactures exporter in the world market in the late 1990s. China has maintained a relatively
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stable exchange rate against the U.S. dollar ever since, which became a foundation for its macroeconomic

stability for over 20 years.

In the long run, the real exchange rate for an open economy is governed by the principle of
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purchasing power parity (PPP). Under a fixed exchange rate, this long-run equilibrium is achieved by

convergence of inflation rates between the domestic and reference foreign countries. Under China’s

managed exchange rate policy since 1994, one may expect the Chinese yuan’s real exchange rate against

the U.S. dollar to have tended toward parity in these 20-plus years. Yet, the Balassa-Samuelson

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hypothesis (Balassa, 1964; Samuelson, 1964) holds that a fast-growing less-developed country in a catch-

up industrialization phase often experiences sizable long-run real exchange rate appreciation (Balassa-

Samuelson effect). Having achieved high growth since the late 1970s, China may fall into this category.

The main objective of this study is to test for the Balassa-Samuelson effect in China and measure

its magnitude during the 1996 to 2015 period. The Chinese yuan’s real exchange rate in this study is taken

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as the index (base year = 1995) of the ratio of China’s GDP deflator to the U.S. chain-type GDP price

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index expressed in a common currency. An increase in the value denotes real exchange rate appreciation,

which originates from either China’s higher (than the U.S.) GDP deflator-based inflation rate or the

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yuan’s nominal exchange rate appreciation against the U.S. dollar. The 20 year time period for this study

saw China maintain a managed exchange rate against the U.S. dollar. The period also represents the

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second leg of China’s rapid growth era, an era which started in 1978 with the economic reform program.
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Because a number of East Asian economies achieved high growth in the past few decades, their
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real exchange rates may have reflected the Balassa-Samuelson effect. Chinn (2000) and Thomas and King
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(2008) examined nine East Asian countries including China to determine whether each country’s GDP

deflator-based real exchange rate and its sectoral labor productivity differential vis-à-vis the U.S. were
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cointegrated as expected under the Balassa-Samuelson hypothesis. The two variables were cointegrated in
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three (Chinn, 1970-1992) and seven (Thomas and King, 1978-2004) of the sample countries. Thomas and

King confirmed cointegration in China while Chinn did not. For 1985-2006, Guo (2010) also reported
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that the two variables, China’s GDP deflator-based real exchange rate and the relative China-U.S. sectoral

labor productivity differential, were cointegrated. Guo’s other finding was that the two countries’ tradable
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price data were generally inconsistent with PPP. If PPP had not held closely for tradables, China’s real

exchange rate may have deviated substantially from its long-run equilibrium for an extended period
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(exchange rate misalignment). However, such deviations may have been small generally. Gan and his

associates (2013) have estimated the long-run equilibrium real effective exchange rate and concluded that

the Chinese yuan was moderately overvalued from 1999 to 2003 and undervalued from 2003 to 2007.

Almas and her associates (2017) found no evidence of the Chinese yuan’s undervaluation with the ICP

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2011 data of a cross section of countries. Although the cointegration test results confirmed the Balassa-

Samuelson effect, we wonder to what extent China’s long-term real exchange rate was driven by the

effect. Tyers and his associates (2008a, 2008b, 2011, 2014) offer a second approach. They used a

generalized Balassa-Samuelson model to decompose China’s real exchange rate change into various

factors and found a small Balassa-Samuelson effect in the 1990s and 2000s. Nevertheless, China’s real

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exchange rate depreciated until around 2002, because several depreciating forces such as trade reforms to

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lower import barriers and financial outflows originating from excess savings outweighed the Balassa-

Samuelson effect.1

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Rapid growth for an extended period in a country does not necessarily bring about real exchange

rate appreciation or the Balassa-Samuelson effect. If long-run real exchange rate appreciation is observed

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in a high-growth country, it is also possible that the appreciation has little to do with the Balassa-
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Samuelson effect. Therefore, we confirm first that China’s real exchange rate appreciated significantly in
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its recent past and the intersectoral productivity growth dynamics in China were generally consistent with
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the Balassa-Samuelson hypothesis. We begin by reviewing the behavior of the real exchange rate and the

pattern of China’s rapid growth (second section). Following the approach of Tyers and his associates, our
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next step is measuring the magnitude of the Balassa-Samuelson effect. Adopting a two-goods, two-factor
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(labor and capital) model, we decompose China’s real exchange rate appreciation vis-à-vis the U.S.

during the 1996-2015 period into three elements, one of which is the Balassa-Samuelson effect (third
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section). In order to estimate the effect, we break up the real exchange rate appreciation into the price
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increases in tradables and nontradables for both China and the U.S. and then match these price changes to

the two productive sectors’ total factor productivity (TFP) growth rates. This procedure relies on the
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1. The decomposition result for 1997-2006 (Tyers et al., 2011) shows that China’s real exchange rate vis-à-vis
a group of world currencies depreciated by 8.1 percent during the period despite the fact that the Balassa-
Samuelson effect was positive (1.6 percent). There were large depreciating effects from trade reforms (−
4.2 percent) and financial outflows (− 4.8 percent).

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national income accounts data. In this paper tradables are manufacturing, mining, and agriculture and

nontradables are broadly-defined services, which include construction and utilities.2

2. Rapid Growth and the Balassa-Samuelson Effect

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2.1 China’s real exchange rate appreciation and the Balassa-Samuelson effect

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According to the Balassa-Samuelson hypothesis, continuous rapid economic growth results in

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real exchange rate appreciation due to long-term productivity growth in the tradable sector relative to the

nontradable sector. The larger the positive productivity growth rate gap is between the tradable and

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nontradable sectors, the faster the real exchange rate will appreciate. A standard case is a young
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industrializing open economy. Assuming PPP for tradables, this economy’s nominal exchange rate settles
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at a level where its tradable prices are equated with those of the reference foreign economy, expressed in
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a common currency. Reflecting high TFP growth, real wages in the tradable sector (largely

manufacturing) are rising in the domestic economy. The wage hikes spread to the nontradable sector
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(largely services) given intersectoral labor mobility. The unit cost increases in the nontradable sector
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whose TFP growth is slow, and the relative price of nontradables rises. An economy’s general price index

is the weighted mean of tradables and nontradables. If expressed in a common currency, the domestic
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economy’s general prices grow faster than those of the reference foreign economy (real exchange rate
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appreciation). Starting from relative backwardness, an upstart industrial power catches up with an

advanced country in the price level expressed in a common currency as well as income per capita over an

extended period. This shows up in a positive relationship between the income and price levels (real
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exchange rate) across countries (the Penn World Table, Feenstra, Inklaar, and Timmer, 2015).

2. Although some services are traded between China and the U.S., the domestic-world price linkages appear
to be generally weaker than the three categories of goods in both countries.

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 The Chinese yuan real exchange rate vis-à-vis the U.S. dollar from 1996 to 2015 is reported in

Table 1. Figure 1 displays the real and nominal exchange rates. The expanding positive gap between the

real and nominal rates in Figure 1 implies that the GDP deflator grew faster in China than in the U.S.

China maintained a fixed rate for nine years from 1996 to 2004 (first period) and a managed float for

eleven years from 2005 to 2015 (second period). In the first period, the real exchange rate moved by a

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small margin (rate of appreciation, annual, 0.4 percent, Table 1, last column) and the cumulative

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appreciation was modest (3.8 percent). Figure 1 shows that the real exchange rate followed the fixed

nominal exchange rate closely from 1995 to 2004. China’s GDP deflator-based inflation rate dropped

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successively and approached the U.S. rate as predicted by PPP. China’s annual inflation rate (2.2 percent,

Table 1, second column) during this period was similar to the U.S. (1.9 percent, fourth column). The fixed

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exchange rate served as a nominal anchor for the Chinese economy in the first period.
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During the second period (2005 to 2015), the nominal exchange rate against the U.S. dollar was
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allowed to move gradually, and the behavior of the yuan real exchange rate changed dramatically.
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Through those 11 years the nominal exchange rate of the yuan appreciated substantially (annual, 2.6

percent) despite the fact that China’s GDP deflator-based inflation rate (annual, 3.9 percent) was
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significantly higher than the U.S. (1.9 percent). Consequently the real exchange rate appreciated by 4.6
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percent annually (last column). Putting the two periods together, the cumulative appreciation from 1996

to 2015 was 70.2 percent. In sum, the Chinese economy experienced large long-run real exchange rate
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appreciation since 1996 with almost all that appreciation occurring in the second period (Figure 1). In

view of China’s rapid output growth relative to the benchmark U.S. economy (real GDP, annual: China,
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9.4 percent; U.S., 2.4 percent, Table 1, third and fifth columns) in this 20-year period, one may suspect

that the observed real exchange rate appreciation was associated with the Balassa-Samuelson effect.
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2.2. Sources of rapid growth: the demand side

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 In order to determine whether the sectoral productivity growth dynamics in China were

responsible for the observed sizable real exchange rate appreciation through the Balassa-Samuelson

effect, we investigate the pattern of China’s economic growth from 1996 to 2015. On the demand side, we

decompose China’s output growth since 1996 into two elements. Let Y, D, X, and M denote, respectively,

real GDP, domestic demand, exports, and imports. Eq. (1) is an accounting identity.

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𝑌 = 𝐷 + 𝑋 − 𝑀. (1)

Real GDP is expressed as the sum of the domestic demand supplied from domestic sources, D ‒ M, and

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exports, X, in Eq. (2).

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𝑌 = (𝐷 − 𝑀) + 𝑋. (2)

Differentiating Eq. (2) with respect to time and dividing by Y, we obtain

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𝑌̂ = 𝜃(𝐷−𝑀) (𝐷̂
− 𝑀) + 𝜃𝑋 𝑋̂, (3)
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where θi is the GDP share and the circumflex above a variable denotes the percentage change. Table 2
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reports the percentage change (upper panel) and the percentage contribution to GDP growth (lower panel)
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of the two demand-side elements in Eq. (3) based on national income accounts data.

China’s systemic transition from a centrally-planned to a market-based economy began in the late
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1970s by adopting an outward-oriented development strategy and implementing liberalization measures

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stepwise in all major productive sectors. Export promotion measures and the open door policy attracted

foreign direct investment centered on light manufactures and electronics in coastal provinces designed
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mainly for exporting finished products to developed countries. Foreign exchange earnings from exports
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enabled China to import capital goods to modernize the manufacturing sector and expand its output

capacity continuously. China became closely integrated with the world economy and its dependence on
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foreign trade grew steadily. Starting from technological backwardness, the manufacturing sector achieved

fast productivity growth, and its output growth generated strong demand for services through backward,

forward, and consumption linkages.

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 The demand-side decomposition for the first period (1996-2004) underscores this growth pattern.

Export demand was the driving force behind output growth (8.9 percent, second column). Exports grew

by 16.7 percent annually (upper panel, last column) and accounted for 52.5 percent of output growth

(lower panel).3 If we consider the indirect effect of the export multiplier, exports’ contribution to output

growth must have been greater than the number reported.4 The bulk of growth in domestic demand

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supplied from domestic sources in the first period (6.0 percent, third column) was presumably accounted

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for by fixed investment, whose nominal GDP share increased from 32.8 percent in 1995 to 39.9 percent in

2004 (NSB-b).

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The second period in the table covers 11 years from 2005 to 2015, which includes the 2008 U.S.

financial crisis and subsequent worldwide recession. China’s output growth rate rose to 9.7 percent from

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8.9 percent in the first period and its growth pattern changed markedly in two distinct ways. First, the
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growth rate of China’s exports dropped to 7.0 percent as world trade growth slowed down. Second,
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China’s industrialization reached a stage where labor-intensive manufactures began to lose comparative
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advantage, and additional growth in manufacturing relied on heavy industry.5 From the first period’s high

marks, fixed investment growth continued to accelerate during the second period, a large part of which
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was in capital-intensive manufacturing, infrastructure, and residential structures. The Chinese government
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countered the global financial crisis of 2008 by adopting expansionary fiscal and monetary policy

centered on ambitious investment programs. The nominal GDP share of fixed investment reached as high
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as 44 percent to 45 percent from 2009 to 2013 (NSB-b). The domestic demand supplied from domestic
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3. A notable factor for high export growth in this period was China’s entry to the WTO in 2001. Other
member countries lowered significantly tariff and nontariff barriers on Chinese products.

4. A noteworthy counter argument is that China’s national accounts overstated the contribution of exports to
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output growth, because China’s domestic demand supplied from domestic sources was underestimated. In
general, the statistical coverage of exports and imports is higher than that of economic activities meeting
the domestic demand in a less-developed country.

5. An interpretation of this structural change is that China passed the Lewis turning point by the mid-2000s.
The modern sector’s continuous expansion exhausted the easily transferrable segment of labor surplus in
the agricultural sector and brought about significant wage pressures in the urban labor markets. Cai and Du
(2011) report that the wages of unskilled workers began to increase rapidly around 2003.

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sources, which was driven by fixed investment, increased by 11.0 percent per year (upper panel, third

column) and contributed to 76.3 percent of output growth (lower panel) in the second period.

2.3 Growth accounting: the supply side

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In reviewing China’s growth on the supply side, we have performed growth accounting based on

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the Solow model. Although this method has commonly been used to investigate the pattern of output

growth, there are limitations and possible biases, two of which stand out (Rodrik, 1997; Nelson and Pack,

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1999; Felipe and McCombie, 2017).6 First, the aggregate production function assumes technical progress

to be Hicks-neutral, which would lead to an underestimation of productivity growth if underlying

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technical progress was labor-augmenting (Harrod-neutral). Second, the measurement procedure and the
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nature of the data used leave TFP growth estimates inexact. Note that TFP growth is computed as the
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difference between output and input growth, and the aggregate variables such as the real GDP (output)
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and capital stock (input) are measured with some errors. Because the aggregate variables satisfy

accounting identities in national income accounts, the procedure almost always yields seemingly plausible
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TFP growth estimates, whose accuracy cannot easily be verified in an alternative method. In estimating
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sectoral TFP growth in China, there is another concern. The GDP in a less-developed country is often

underestimated because of low statistical coverage in some economic activities. In China’s case, services
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output is presumably poorly measured relative to manufacturing, and therefore the measurement error in

nontradable output is likely greater than tradables. If China’s national income accounts understated the
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growth in services output in the recent past, the nontradable sector’s TFP growth estimates would be
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6. Two of the well known examples of growth accounting based on the Solow model for China’s reform
period are Young (2003) and Bosworth and Collins (2008).

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biased downward.7 These caveats apply to our accounting results in this section and 3.2, and therefore the

results displayed should be regarded as approximations with some ranges of errors.

Table 3 reports the economy-wide and two sectoral (tradable and nontradable) growth accounting

results. The aggregate level decomposition in the first panel shows that from 1996 to 2015 more than half

of output growth (9.4 percent per year, second column) was attributed to capital accumulation (5.3

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percent, sixth column), the remainder largely to TFP growth (3.7 percent, fifth column), and the increase

in labor’s contribution was small (0.4 percent, last column). High TFP growth underscores the fact that

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China not only mobilized savings for fixed investment but its newly-added capital stock embodied

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advanced technology. This capital accumulation-driven growth pattern was more pronounced in the

second period. Output growth acceleration from 8.9 percent in the first period to 9.7 percent in the second

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was achieved by expanding capital stock at a higher rate. The increase in capital stock contributed to
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output growth by 5.8 percent as compared to 4.6 percent in the first period.
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The accounting results of the two sectors in the lower panels show that output growth in the
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nontradable sector was faster than in the tradable sector in those 20 years. Note that the tradable sector

includes agriculture whose growth was slow compared to other sectors. The agricultural sector kept
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shedding workers throughout the period, and a majority of the displaced moved to the service sector.
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While the tradable sector’s employment decreased, continuous increases in work force of the nontradable

sector facilitated its output expansion.

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Nevertheless, TFP growth in the tradable sector (5.4 percent, second panel) was much higher than
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in the nontradable sector (1.7 percent) during the period. Massive investment in fixed capital presumably

had the greatest impact on technological progress in manufacturing, the core of the tradable sector.

Another source of the high TFP growth was the reallocation of labor from agriculture to manufacturing.
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7. There is some evidence for high services productivity growth in recent years that is unlikely to have been
captured fully in China’s official statistics. Zhang and Zhu (2015) examined Alibaba’s sales data and found
that E-commerce greatly facilitated transactions between sellers in existing urban industrial clusters and
buyers in distant rural locations in inland provinces. E-commerce’s fast expansion must have contributed to
the growth in various support service businesses, large and small, in addition to manufacturing.

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Because the marginal product of labor in China’s agricultural sector was low, transferring labor from

agriculture to manufacturing―holding each subsector’s TFP constant―would have increased the output

and TFP of the tradable sector (labor reallocation effect). As agricultural employment dropped at an

accelerating rate over the 20-year period, the magnitude of the labor reallocation effect in the tradable

sector’s TFP growth may have risen over time.8 The TFP growth rate in the tradable sector increased

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from 4.7 percent in the first period to 5.9 percent in the second. The Chinese economy was in the catch-up

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industrialization phase since the late 1970s and its high point coincided with the second period. Those 11

years were the time period when China’s tradable sector achieved quite high TFP growth and the real

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exchange rate of the yuan appreciated greatly. The coincidence of the two events appears to be a textbook

case of the Balassa-Samuelson effect. The next step is decomposing the observed real exchange rate

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appreciation into several elements based on the Balassa-Samuelson model.
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3. Decomposition of the Long-Term Real Exchange Rate Appreciation
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3.1 Decomposition in terms of tradable prices and the relative price of nontradables
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With the Balassa-Samuelson—two-goods (tradables and nontradables), two-factor (labor and

capital) open-economy—model, we have derived equations to account for the long-term real exchange
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rate appreciation of the Chinese yuan vis-à-vis the U.S. dollar (see Appendix A). In the simpler first
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version, the yuan real exchange rate appreciation (LHS) is decomposed into three terms:

     
Pˆ  Eˆ  Pˆ *   PˆN  PˆT   PˆN*  PˆT*  PˆT  Eˆ  PˆT* . (4)
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8. Persons engaged in agriculture dropped from 355.3 million in 1995 to 348.3 million in 2004 and to 219.2
million in 2015. There were corresponding increases in persons engaged in manufacturing and mining
(1995, 120.8 million; 2004, 120.8 million; 2015, 136.2 million) and the nontradable sector (204.6, 273.5,
and 419.1 million, respectively) during the period (NBS-b). Because detailed sectoral data are unavailable,
we cannot estimate the magnitude of the labor reallocation effect in the tradable sector’s TFP growth.
Although the effect must account for part of the increase in the TFP growth rate from the first to second
periods, the magnitude could be modest if a careful estimation procedure was followed (Ye and Robertson,
2017).

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P is the GDP deflator for China and the chain-type GDP price index for the U.S. E is the nominal

exchange rate (yuan per U.S. dollar). The U.S. variables are asterisked. A circumflex above a variable

denotes the percentage change. P is the geometric mean of the price indexes of nontradables (PN) and

tradables (PT). β (γ) denotes the nominal GDP share of nontradables in China (the U.S.).

Pˆ  Eˆ  Pˆ *  I  II  III . (5)

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Let us rename the three RHS terms in Eq. (4) as I, II, and III in Eq. (5). I and II indicate the impact of the

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change in the relative price of nontradables in China [PN/PT] and the U.S. [PN*/PT*], respectively, on the

yuan real exchange rate. The difference of these two terms, I − II, represents the joint effect of the relative

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price of nontradables. If China’s (nontradables value share-weighted) relative price rises significantly

faster than that of the U.S., this increases the yuan real exchange rate.

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If PPP held for tradables and the value composition of tradables in the two countries were
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identical, the first two terms would determine fully the long-term yuan real exchange rate against the U.S.
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dollar. Therefore, the last term (III)―the real exchange rate appreciation in tradables―represents the
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deviation from PPP and the output composition difference in tradables. The main sources of the deviation

from PPP in tradable prices are imperfect integration of international goods markets, pricing to market,
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and short-term nominal price rigidities (Rogoff, 1996).

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Table 4 reports the sectoral prices of the two countries. China’s rapid growth was accompanied
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by higher price increases in both sectors (tradables, 1.9 percent, and nontradables, 4.2 percent; bottom

row, second and third columns) relative to the U.S. (0.1 percent and 2.3 percent, fourth and fifth columns)
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during the 20-year period. Nontradable prices rose faster than the tradable prices in both China and the

U.S., which confirms the presence of a productivity growth rate gap between the two sectors observed in
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many countries. The rates of price increase for both sectors in China rose from the first (1.1 percent and

3.5 percent) to second period (2.5 percent and 4.8 percent). Notably, the price increase in nontradables

decelerated somewhat (from 2.4 percent to 2.1 percent) in the U.S.

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 We applied the 1995-2015 data in Tables 1 and 4 to Eq. (5). The results expressed as the annual

percentage changes are in Table 5. The relative price of nontradables grew faster in China (2.3 percent,

third column) than in the U.S. (2.1 percent, fourth column) during those 20 years. However, in Eq. (4)

each country’s term is weighted by the nontradable sector’s nominal GDP share, which is much greater in

the U.S. (γ, period mean, 0.837) than in China (β, 0.507). Relative to the U.S., China was in a lower stage

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of economic development where the service sector was smaller and less developed. Consequently, the

change in the relative price of nontradables (I ‒ II) had a moderately negative effect on the yuan real

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exchange rate (‒ 0.6 percent, fifth column). It was a large real appreciation in tradables (3.2 percent. sixth

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column) that increased the real exchange rate (2.7 percent, second column).

The results on the two subperiods are mixed. The change in the relative price of nontradables had

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a negative effect (‒ 1.4 percent) on the real exchange rate in the first period (1996-2004), because China’s
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relative price of nontradables (2.4 percent) grew slower than the U.S. (3.1 percent). During the second
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period (2005-2015), however, the rise in China’s relative price of nontradables (2.3 percent) was greater
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than the U.S. (1.3 percent) and yielded a small positive effect (0.1 percent) on the yuan real exchange

rate. This confirms that the steep real exchange rate appreciation in the second period (4.6 percent) was
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almost entirely attributed to real appreciation in tradables (4.4 percent).

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3.2. Decomposition: the Balassa-Samuelson effect and others

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In order to assess the magnitude of the Balassa-Samuelson effect, Eq. (4) is modified (see
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Appendix A). To start, the first and second terms on the RHS, which represent the change in the relative

price of nontradables (PN/PT), are replaced by three terms in Eq. (6). The rise in the relative price of

nontradables derives from the gap in the TFP growth rates between the tradable and nontradable sectors
A

of both countries. The first two terms of Eq. (6) together represent the Balassa-Samuelson effect (i.e., the

joint effect of the tradable-nontradable productivity growth difference between the two countries) on the

yuan real exchange rate vis-à-vis the U.S. dollar. αN (αT) denotes the share elasticity of labor in the

production function of the nontradable (tradable) sector. AT (AN) is the TFP level of the tradable

14
(nontradable) sector. However, in the short run, the demand-side disturbances in either of the two

countries also affect the relative price of nontradables. The third term of Eq. (6) indicates the joint effect

of the demand-side disturbances in China (Ib) and the U.S. (IIb) on the relative prices of nontradables in

the two countries (see Appendix A for details). Ib (IIb) is the difference between the first (second) term of

Eq. (4) and the first (second) term of Eq. (6).

PT
      
Pˆ  Eˆ  Pˆ *    N / T AˆT  Aˆ N    N* / T* AˆT*  Aˆ N*  Ib  IIb   PˆT  Eˆ  PˆT* . (6)

RI
The tradable price term, the fourth RHS term, would affect the yuan real exchange rate if PPP

fails in tradables and the output composition of tradables is substantially different between the two

SC
countries. We rename the first two RHS terms in Eq. (6) as Ia and IIa and the last as III in Eq. (7).

Pˆ  Eˆ  Pˆ *  I a II a   I b IIb   III . (7)

U
N
Table 6 reports TFP estimates in the two countries for the 20-year period based on the Solow

model in which labor and capital are the inputs. China achieved TFP growth higher than the U.S. in both
A
tradable and nontradable sectors throughout the period. The tradable sector’s TFP growth was faster than
M

that of the nontradable sector in both countries. During the first period (1996-2004), which overlapped
D

with the decade of broad adoption of information technology by U.S. producers, the U.S. tradable sector
TE

achieved remarkably high TFP growth (4.5 percent per year, sixth column). This left the sectoral

productivity growth gap in China (tradable, 4.7 percent; nontradable, 2.1 percent) smaller than in the U.S.
EP

(4.5 percent and 1.1 percent). In the second period (2005-2015) however, China’s sectoral productivity

growth gap (5.9 percent and 1.3 percent) was greater than that of the U.S. (1.2 percent and 0.5 percent).
CC

While U.S. productivity growth slowed down around the mid-2000s, China’s fixed investment-led output

growth was accompanied by high productivity growth in the tradable sector.

A

We applied the 1995-2015 data in Tables 1, 4, 5, and 6 to Eq. (7). The results are expressed as the

annual percentage changes in Table 7. Over the full 20 years and the first period, the contribution of the

sectoral productivity growth gap to the yuan real exchange rate appreciation was negative (‒ 0.7 percent

and ‒ 2.9 percent, fifth column). This cannot be regarded as the Balassa-Samuelson effect, which

15
increases the real exchange rate in a high growth economy. Nevertheless, in the second period (2005-

2015) we observe a moderate Balassa-Samuelson effect (1.2 percent) on the yuan real exchange rate.

China was in the middle of fast structural and technological transformation then. There were some short-

term demand-side disturbances in both economies (sixth and seventh columns), which had a positive

effect (1.5 percent, eighth column) during the first period and negative (− 1.1 percent) during the second.

PT
Although we have found the Balassa-Samuelson effect during the second period, China’s real exchange

RI
rate appreciation then (4.6 percent, second column) was mainly driven by real appreciation in tradables

(4.4 percent, ninth column). The observed real exchange rate appreciation was simply too large to be

SC
attributed mainly to the Balassa-Samuelson effect. Although high TFP growth (5.9 percent) in China’s

tradable sector resulted in a large sectoral TFP growth gap (4.5 percent, third column) during the second

U
period, this gap turned into a modest Balassa-Samuelson effect, because China’s nontradable sector’s
N
GDP weight (β) was smaller than that of the U.S. (γ) in Eq. (6).
A
M

4. Concluding discussion

We have investigated the long-term behavior of the Chinese yuan real exchange rate vis-à-vis the
D

U.S. dollar for 20 years from 1996 to 2015, a period in which China maintained a managed nominal
TE

exchange rate. In the first period (1996-2004) the yuan was pegged to the U.S. dollar, and the real

exchange rate appreciated marginally (appreciation, 0.4 percent per year). China moved to a managed
EP

float in 2005, and during the second period (2005-2015) the yuan’s real exchange rate appreciated at a

high rate (4.6 percent per year). China’s real exchange rate appreciation for 2005-2015 appears to be a
CC

classic example of the Balassa-Samuelson effect. China achieved continuous rapid output growth vastly

faster than the U.S. Technological and industrial upgrading centered on manufacturing resulted in high
A

TFP growth in China’s tradable sector (5.9 percent per year). The decomposition in this paper confirmed

the Balassa-Samuelson effect in the second period, which accounted for 1.2 percentages points of the

annual 4.6 percent real exchange rate appreciation of the yuan. Although the estimated magnitude

depends on the breadth of the tradable sector definition and the extent of inaccuracies in TFP estimates,

16
alternative measurements are unlikely to change the finding that the Balassa-Samuelson effect was

present but its magnitude was relatively small. By far the greatest source of the yuan’s real exchange rate

appreciation for those 11 years was real appreciation in the prices of China’s tradables (4.4 percent per

year), which seemingly goes counter to PPP. These results leave us wondering whether the oft-observed

sizable long-term real exchange rate appreciation in fast growing industrializing countries can more

PT
generally be attributed mainly to the Balassa-Samuelson effect.

RI
Our estimates from China for 2005-2015 are not an exception. Japan during its rapid growth era,

for 1956-1970, experienced GDP deflator-based real exchange rate appreciation against the U.S. dollar of

SC
2.7 percent per year; the Balassa-Samuelson effect accounted for 0.7 percent while the real appreciation

in tradables accounted for 1.9 percent (Imai, 2010). Central and Eastern European transition economies

U
also experienced substantial real exchange rate appreciation vis-à-vis Western European currencies and
N
the euro during high growth years in the 1990s and 2000s. A consensus is that the Balassa-Samuelson
A
effect was small relative to the magnitude of real exchange rate appreciation at that time. The effect in ten
M

transition economies for 1997-2007 based on labor productivity data fell between zero and 2 percent per

year (Égert, 2010). For 11 countries from the mid-1990s to 2007, the Balassa-Samuelson effect accounted
D

for a mean of 0.8 percentage points (1.2 percentage points under an alternative method) of 3.5 percent
TE

annual real exchange rate appreciation (Mihaljek and Klau, 2004 and 2009).9 In all three cases, China,

Japan, and the Central and Eastern European countries, it was not the Balassa-Samuelson effect but real
EP

appreciation in tradables that was responsible for the bulk of real exchange rate appreciation.

The fact that those countries’ tradables prices expressed in the common currency continued to
CC

increase for a decade or longer―leading to a continuous real exchange rate appreciation―looks unusual
A

in view of competitive international markets. Two main factors for this long-term real appreciation in

tradables are imperfect integration of international goods markets and the difference in commodity

9. Averaging results from the 11 Central and Eastern European countries, these countries experienced a
nominal currency depreciation of 1.5 percent per year and their annual rate of inflation was 5.0 percentage
points higher than the euro area, implying a 3.5 percent real exchange rate appreciation (Mihaljek & Klau,
2009).

17
composition across countries. Forces leading to price convergence would be weak unless domestic and

foreign markets were closely linked. Price increases in the domestic country’s tradables relative to the

reference foreign country would arise over time if the former’s GDP deflator for tradables is heavily

weighted in goods for which prices rise relatively fast. This second factor played a role in Central and

Eastern European countries’ real exchange rate appreciation (Égert, Lommatzsch, & Lahrèche-Révil,

PT
2006; Égert, 2010). Unleashing private business, curtailing price controls, and liberalizing foreign trade

RI
and investment resulted in a wholesale retooling of the manufacturing sector in those transition

economies. Income increases during the high growth period shifted consumption patterns in favor of

SC
higher-priced and higher-quality goods. The manufacturing sector’s output mix also shifted towards

higher value-added goods with higher quality and increasing prices.10

U
Were these two factors present in the observed substantial real appreciation in China’s tradables
N
for 2005-2015? Measuring the effects would require detailed industry-level nominal and real output data
A
and is beyond the scope of this paper. What we have are the data for the two components of the tradable
M

sector, manufacturing/mining and agriculture, with which China’s sectoral real exchange rate appreciation

was computed (Table 8). Because China’s GDP deflator for agriculture grew much faster than that of the
D

U.S. during the second period (2005-2015, 5.7 percent and 0.2 percent, fourth column), real appreciation
TE

for China’s agricultural goods prices was as high as 8.2 percent per year (fourth panel). Although China

actively participated in international trade of agricultural products, domestic markets were not strongly
EP

linked with international markets for many agricultural products, often due to perishability and high
CC

transportation and storage costs.11 Rising incomes and changes in consumer tastes may have resulted in

10.
A

Part of the observed price increases in products whose quality improved came from inaccuracies in official
statistics (Égert, 2010). Price increases that correspond to quality improvement must be regarded as
increases in output quantities. Because of incomplete adjustments for product quality improvement in
official statistics, we suspect some upward bias in the price data and matching downward bias in the output
data in Central and Eastern European countries.

11. China’s agricultural trade volume is significantly large. In 2014 China’s agricultural sector GDP was
5,833.6 billion yuan, and agricultural exports and imports were 69.4 and 108.2 billion U.S. dollars,
respectively (NBS-a and -b). The export and import ratios to agricultural output were 7.3 percent and 11.4
percent, respectively, with prices converted at the exchange rate (6.143 yuan per U.S. dollar).

18
strong demand and price increases in those agricultural products with limited access to overseas markets.

Agriculture’s value weight in China was high (2015, 22.1 percent vs. U.S., 7.3 percent, last column).

Because real appreciation in the prices of manufacturing and mining products during the period was 3.8

percent per year (fourth panel, third column), the extraordinary increase in China’s agricultural prices

raised the real appreciation in China’s tradables prices by 0.6 to 4.4 percentage points (second column).

PT
Although China’s manufacturing and mining sectors were, arguably, linked closely to

RI
international markets through trade, continuous real appreciation in the prices of manufacturing and

mining products over the 11 years reached 3.8 percent annually. In view of China’s accelerated industrial

SC
modernization, we suspect that the commodity composition of its manufactures changed substantially in

favor of goods for which prices rose relatively fast.12 To the extent that the composition change was

U
greater in China than in the U.S., the prices of China’s manufactures would have risen at a faster rate than
N
those of the U.S. Considering the production side, high fixed investment brought about fast output growth
A
in China’s manufacturing. Assuming firm managers’ investment decisions based on conventional
M

investment criteria, capacity expansion must have been faster in products that generated greater value

added. Because higher prices as well as TFP growth increase value added, the output mix in China’s
D

manufactures presumably shifted toward products with faster price growth over time.
TE

The Balassa-Samuelson hypothesis explains how output growth and structural transformation in a

catch-up economy result in continuous real exchange rate appreciation. The question remains as to
EP

whether the effect was the main source of observed long-term real exchange rate appreciation. Despite the

demonstrated presence of the Balassa-Samuelson effect, the bulk of China’s real exchange rate
CC

appreciation from 2005 to 2015 was accounted for by a continuous rise in China’s tradables prices

expressed in a common currency. And it is this same pattern that was found in other countries during their
A

12. A piece of anecdotal evidence for the substantial composition change is the transition of major export
commodities. Hanson (2012) reported that on the SITC 4-digit level China’s two largest exports in 1994
were footwear (7.3 percent of commodity exports) and children’s toys (7.0 percent). The three largest
exports in 2008 were completed computers (4.5 percent), children’s toys (3.5 percent), and cellphones,
TVs, and radio transmitters (3.0 percent).

19
high growth periods. This directs attention to identifying other structural forces working through the

prices of tradables to generate real exchange rate appreciation in high growth economies.

Acknowledgment: I am grateful to Kenneth W. Clements, Yang Yao, and two anonymous referees for

PT
helpful comments and Kazuhiro Magome for research assistance.

RI
SC
U
N
A
M
D
TE
EP
CC
A

20
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23
Appendix A: Derivation of Equations (4) and (6)

The procedure was adapted from several versions of the Balassa-Samuelson model (Asea &

Corden, 1994; Froot and Rogoff, 1995; Tyers et al. 2008b). China’s price index (P) is expressed as a

geometric mean of the nontradable and tradable prices, PN and PT, in Eq. (A1). β is the value weight of

nontradables in the price index. The same relationship holds in the U.S. The asterisks denote U.S.

PT
variables in Eq. (A2), and γ is the value weight of nontradables in the U.S. The U.S. price index (P*) is

RI
expressed in the Chinese yuan by multiplying it by the Chinese yuan exchange rate, E (yuan per U.S.

dollar).

SC
P  PN PT1   . (A1) EP * = EPN* PT*1  . (A2)

Rearranging Eqs. (A1) and (A2), we obtain

U
 
P   P* 
P   N  PT
 PT 
(A3) N EP   N*  EPT* .
*

 PT 
(A4)
A
Eq. (A5) expresses the ratio of the price levels in the two countries:
M

 P  PN / PT  PT


 EP *   * *  * .
(A5)
 
 PN / PT EPT 
D

Based on Eq. (A5), the Chinese yuan’s real exchange rate appreciation―an increase in the LHS
TE

value―can be decomposed into three elements in Eq. (4). A circumflex above a variable denotes the
EP

percentage change.

If the time frame were long enough for the supply side to adjust fully to price changes, the rise in
CC

the relative price of nontradables (PN/PT)―the first two RHS terms of Eq. (4)―would match the

weighted difference in the TFP growth rates between the tradable and nontradable sectors in each of the
A

two countries.13 A gap appears between the two when the observed data are used, because the data points

13. This relationship assumes: (a) a Cobb-Douglas production function with constant returns to scale; (b)
perfect competition in goods and factor markets; (c) labor is mobile across sectors but immobile
internationally; and (d) capital is mobile both across sectors and internationally. The author believes that

24
do not represent the long-term equilibria. Considering such a gap, the first two terms of Eq. (4) can be

replaced by

  
 PˆN  PˆT    N T AˆT  Aˆ N  I b where I b   [( PˆN  PˆT )  {( N / T ) AˆT  Aˆ N }] (A6)

   
 PˆN*  PˆT*    N* T* AˆT*  Aˆ N*  II b where II b   [( PˆN*  PˆT* )  {( N* / T* ) AˆT*  Aˆ N* }]. (A7)

PT
AT (AN) in Eqs. (A6) and (A7) is the TFP level of the tradable (nontradable) sector. αN (αT) denotes the

share elasticity of labor in the production function of the nontradable (tradable) sector. The difference

RI
between the first RHS terms of Eqs. (A6) and (A7) is the Balassa-Samuelson effect. Ib and IIb are the gap

between the change in weighted relative price and relative TFP growth in each country. The gaps are

SC
largely attributed to demand shocks. A demand shock in China (the U.S.) may show up as a change in the

U
relative price of nontradables in Ib (IIb) in the short run, because output is slow to respond to the shock.

N
Demand shocks include fiscal policy, commercial policy, consumer taste changes, and changes in export

demand. We name (Ib − IIb) as the short-run demand-side effect. Substituting Eqs. (A6) and (A7) into (4),
A
the Chinese yuan’s real exchange rate appreciation vis-à-vis the U.S. dollar is decomposed into four
M

elements in Eq. (6).

D
TE
EP
CC
A

the Chinese economy approximately meets these assumptions in a relatively long time frame and that
measurement exercises based on the standard Balassa-Samuelson model yield meaningful results.

25
Appendix B: Data Definitions and Sources

1. Chinese Data

C1. GDP and its demand components in current and constant prices and GDP deflators: NBS-a and -b
and Asian Development Bank (2016). The GDP deflator computed is the ratio of the current to
constant-price GDP indexed to 1995. The deflator for exports is the tradable sector’s deflator (see
C3). The deflator for imports is the unit price index for world imports (International Monetary
Fund) converted to the Chinese yuan with the exchange rate (C2).

PT
C2. Chinese yuan nominal exchange rate: yuan per U.S. dollar, annual average, NBS-a and -b.

RI
C3. Sectoral GDP and deflators: NBS-a and -b. The sectoral deflator is nominal output divided by real
output. The tradable sector is the sum of agriculture, mining, and manufacturing. The nontradable
sector represents the rest: all private service trades and government services in addition to

SC
construction and electric power and water.

C4. Sectoral labor input: NBS-a, -b, and -c. The number of persons engaged by economic activity.
Construction is included in the nontradable sector. The data for the number of persons engaged in

U
construction (A series) were unavailable from 2003 onward in NBS-c. NBS-a and -b list the
number of persons employed by construction enterprises (B series) up to 2015. Because the (B) to
N
(A) ratio was around 0.55 to 0.6 for several years to 2002, the missing observations in (A) from
2003 to 2015 were estimated with (B) assuming the constant (B) to (A) ratio at the 2002 level
A
(0.577).

C5. Sectoral capital stock: NBS-a and -b. Capital stock is estimated from gross domestic fixed capital
M

formation and changes in inventory. Changes in inventory in current price are converted to 1995-
constant price series by the GDP tradables deflator. Domestic fixed capital formation in current
prices is deflated by the price index for investment in fixed assets to turn into the 1995-price
D

series. Because this price index’s starting year is 1990, the deflator prior to 1990 is a weighted
sum of the sectoral GDP deflators of industry and construction. The sum of this series and
TE

inventory changes in 1995 prices represents gross investment. Upon reconstructing the capital
stock series starting from 1978 with annual gross fixed and inventory investment and the rate of
depreciation, two assumptions are made. The capital stock at the end of 1977 was twice as large
as the 1978 GDP and the annual rate of depreciation was constant at 5.0 percent. In the absence of
EP

sectoral investment data, the reconstructed total capital stock value is distributed to the two
sectors according to the sectoral shares of capital income. This computational method assumes
the rental of capital to be identical across the two sectors. This assumption may be a good
CC

approximation over a relatively long period of time.

C6. Sectoral labor and capital income and their value-added shares: NBS-a and -b. After deducting
net indirect taxes, value-added at current prices by industry consists of labor payment (income),
gross operating surplus, and depreciations. The sum of the last two is capital income. By
A

deducting the labor income share (of value added) from unity, the output share elasticity of
capital is obtained. Sectoral labor and capital income is computed by distributing sectoral value-
added according to these output share elasticities.

C7. TFP indexes: Based on the Cobb-Douglas production function (Y = ALαK(1 − α)) with an output (Y)
and labor (L) and capital (K) inputs, the Solow residual is computed as A’s log difference for each
sector. α and (1 − α) are assumed to be constant at the mean of the observed output share
elasticity of each factor (the labor income share of value-added for example) for the 1995-2014

26
 period. The values are the means of the eight years that the factor payment by industry data were
available (1995, 1997, 2000, 2002, 2005, 2007, 2010, and 2012, NBS-a).

2. U.S. Data

U1. Nominal and real (2009 chained dollars) GDP and the chain-type GDP price index: Bureau of
Economic Analysis (BEA), Department of Commerce, website (accessed August 2016).

PT
U2. Sectoral output and price indexes: The GDP by industry is available in current prices and chain-
type quantity indexes at the BEA website. We have classified industries into tradable and
nontradable sectors. The tradable sector consists of manufacturing, mining, and agriculture in the

RI
private industries. The remaining private industries and the government represent the nontradable
sector. Sectoral output is constructed with the industry-level current-price series and chain-type
quantity index series. Aggregation errors are adjusted. The price indexes are computed for the

SC
two sectors.

U3. Sectoral labor input: The sum of hours worked by employees (BEA website, Table 6.9) and hours
worked by the self-employed is computed for the tradable and nontradable sectors. The ratio of

U
full-time equivalent employees (Table 6.5) to persons engaged (Table 6.8) is computed first.
Hours worked by employees are divided by this ratio. Note that the difference between full-time
N
equivalent employees and persons engaged is self-employed persons. This computation method
assumes that, on average, hours worked by a self-employed person are the same as those by a
A
full-time employee.

U4. Sectoral capital input: The value of capital service from fixed private capital and land is estimated
M

for the tradable and nontradable sectors. To begin with, the fixed private capital (the sum of
equipment, structures, and intellectual property products) series is constructed with current-price
series and the chain-type quantity index series (BEA website). Land is included with its 1990
D

market value as the weight (Board of Governors of the Federal Reserve System, 1991). The value
of capital service per dollar’s worth of capital stock here is the sum of depreciation and interest
TE

payment. Considering the economic depreciation rates in Jorgenson and Stiroh (2000, Table B1),
the depreciation rates of 0 percent, 2.5 percent, and 15 percent are applied to land, structures, and
all other capital. The interest rate adopted is the mean of the prime rate in the U.S. during the
1995-2014 period (5.90 percent, Council of Economic Advisors, 2015). Two other assumptions
EP

are made: (a) The total land area is constant at the 1990 level and (b) 25 percent of value-
weighted land is used by the tradable sector.
CC

U5. Sectoral labor and capital income and the output share elasticities of labor and capital: Current-
price sectoral output net of indirect business taxes and nontax liabilities (BEA website) represents
total factor payment. The sum of compensation of employees and labor income of the self-
employed represents total labor income. The ratio of full-time equivalent employees to persons
engaged (see U3) is used to estimate total labor income; compensation of employees is divided by
A

this ratio. Capital income is the difference between total factor payment and total labor income.
The factor payment shares of total labor income and capital income computed here are the output
share elasticities of labor and capital, respectively.

U6. Sectoral TFP indexes: The estimation method is identical to C7. The output share elasticities are
assumed to be constant at the mean of the 1995-2015 period.

27
 Table 1

Rate of Inflation, GDP Growth, and the Real Exchange Rate:

China and the U.S.

China U.S.
(Growth rate, %) (Growth rate, %) Nominal Yuan Real

PT
GDP Exchange Exchange
GDP Real Price Real Rate (E) Rate (RER)
Year Deflator GDP Index GDP (Yuan/1US$) (1995=100)

RI
1995 13.7 11.0 2.1 2.7 8.351 100.0
1996 6.5 9.9 1.8 3.8 8.314 105.1

SC
1997 1.6 9.2 1.7 4.5 8.290 105.3
1998 − 0.9 7.9 1.1 4.4 8.279 103.3
1999 − 1.3 7.6 1.4 4.7 8.278 100.6
2000 2.0 8.4 2.3 4.1 8.278 100.3

U
2001 2.0 8.3 2.3 1.0 8.277 100.1
2002 0.6 9.1 1.5 1.8 8.277 99.2
2003
2004
2.6
6.9
10.0
10.1
2.0
2.7
N2.8
3.8
8.277
8.277
99.8
103.8
A
2005 3.9 11.4 3.2 3.3 8.192 105.5
2006 3.9 12.7 3.1 2.7 7.972 109.3
M

2007 7.8 14.2 2.7 1.8 7.604 120.4

2008 7.8 9.6 1.9 − 0.3 6.945 139.4
2009 − 0.1 9.2 0.8 − 2.8 6.831 140.5
D

2010 6.9 10.6 1.2 2.5 6.770 149.7

2011 8.1 9.5 2.1 1.6 6.459 166.3
TE

2012 2.4 7.8 1.8 2.2 6.313 171.1

2013 2.2 7.7 1.6 1.7 6.193 175.4
2014 0.8 7.3 1.8 2.4 6.143 175.2
2015 − 0.4 6.9 1.1 2.6 6.228 170.2
EP

Annual growth rate, %

1996-2004 2.2 8.9 1.9 3.4 − 0.1 0.4
CC

2005-2015 3.9 9.7 1.9 1.6 − 2.6 4.6

1996-2015 3.1 9.4 1.9 2.4 − 1.5 2.7

Note. The Chinese yuan real exchange rate (RER) is computed as (P/EP*) and indexed to the 1995 level,
A

where P, P*, and E are, respectively, the GDP deflator in China, the chain-type GDP price index in the
U.S., and the Chinese yuan exchange rate against the U.S. dollar (yuan per dollar). Source: Appendix B
(C1, C2, and U1) and author’s calculations.

28
 Table 2

Growth Decomposition, the Demand Side: China

Period 𝑌̂ (𝐷̂
− 𝑀) 𝑋̂

Annual growth rate, %

PT
1996-2004 8.9 6.0 16.7
2005-2015 9.7 11.0 7.0
1996-2015 9.4 8.7 11.3

RI
SC
𝑌̂ 𝜃(𝐷−𝑀) (𝐷̂
− 𝑀) 𝜃𝑋 𝑋̂

Contribution to GDP growth, %

U
1996-2004 (100.0) 47.5 52.5
2005-2015 (100.0) 76.3 23.7
1996-2015 (100.0) 69.6 30.4
N
Note. The variables (in 1995 prices) are: Y, GDP; D−M, domestic demand supplied from domestic
A
sources; and X, exports. θi is the GDP share. Source: Appendix B (C1-2) and author’s calculations.
M
D
TE
EP
CC
A

29
 Table 3

Growth Accounting, the Supply Side: China

Contribution
Period 𝑌̂ ̂
𝐾 𝐿̂ 𝐴̂ ̂
(1 − 𝑊𝐿 )𝐾 𝑊𝐿 𝐿̂

Annual growth rate, %

PT
All sectors
1996-2004 8.9 10.4 1.0 3.7 4.6 0.6
2005-2015 9.7 13.2 0.4 3.6 5.8 0.3

RI
1996-2015 9.4 11.9 0.7 3.7 5.3 0.4

Tradable sector

SC
1996-2004 8.5 9.4 − 0.2 4.7 3.9 − 0.1
2005-2015 9.0 11.0 − 2.3 5.9 4.5 − 1.4
1996-2015 8.8 10.3 − 1.4 5.4 4.2 − 0.8

U
Nontradable sector
1996-2004 9.5 11.6 3.4 2.1 5.6 1.8
2005-2015
1996-2015
10.5
10.1
15.0
13.4
3.9
3.7
N 1.3
1.7
7.2
6.5
2.0
1.9
A
Note. The variables are: Y, GDP in 1995 prices; K, capital stock; L, number of workers; A, total factor
M

productivity; WL is the labor income share of GDP. Source: Appendix B (C1 and C3-7) and author’s
calculations.
D
TE
EP
CC
A

30
 Table 4

Sectoral Prices: China and the U.S.

China U.S.

Prices Prices

PT
(GDP deflator, 1995=100; growth rate, %) (GDP price index, 1995=100)

Year Tradables Nontradables Tradables Nontradables

RI
1995 100.0 15.4 100.0 11.3 100.0 100.0
1996 106.2 6.2 107.0 7.0 101.7 101.9
1997 105.6 ‒ 0.5 111.8 4.5 100.1 104.3

SC
1998 101.1 ‒ 4.3 115.6 3.5 96.7 106.5
1999 97.9 ‒ 3.2 116.7 0.9 95.2 108.8
2000 98.5 0.7 120.6 3.4 94.9 111.8
2001 99.2 0.6 124.5 3.2 94.0 115.2

U
2002 98.6 ‒ 0.6 126.4 1.5 91.7 117.9
2003 101.1 2.5 129.8 2.7 93.2 120.3
2004
2005
110.0
114.7
8.8
4.3
136.3
140.6
N5.0
3.1
94.4
98.3
123.8
127.6
A
2006 119.4 4.1 145.4 3.4 99.5 131.9
2007 128.1 7.3 157.1 8.0 100.9 135.8
2008 138.9 8.4 168.4 7.2 104.8 137.9
M

2009 134.0 ‒ 3.5 173.2 2.9 98.8 140.7

2010 143.2 6.9 185.5 7.1 102.0 141.9
2011 154.2 7.6 201.5 8.7 108.8 143.7
D

2012 153.9 ‒ 0.2 210.7 4.5 110.3 146.4

2013 153.3 ‒ 0.4 219.5 4.2 110.4 149.2
‒ 1.4
TE

2014 151.1 224.6 2.4 110.2 152.4

2015 144.6 ‒ 4.3 229.3 2.1 103.0 156.3

Annual growth rate, %

‒ 0.6
EP

1996-2004 1.1 3.5 2.4

2005-2015 2.5 4.8 0.8 2.1
1996-2015 1.9 4.2 0.1 2.3
CC

Source: Appendix B (C3 and U2) and author’s calculations.

A

31
 Table 5

Eq. (5) in Percentage Points

LHS RHS

Real

PT
Appreciation
Real Exchange Relative Price of Nontradables in Tradables Error
Rate

RI
Appreciation China U.S.
Year III LHS
Pˆ  Eˆ  Pˆ *  
PˆN  PˆT  Pˆ *
N  PˆT*  I−II Pˆ  Eˆ  Pˆ 
T T
*  RHS

SC
Growth rate, %

1996 5.1 0.7 0.3 0.1 4.9 0.1

U
1997 0.2 5.0 3.9 − 1.0 1.3 − 0.1
1998 − 1.9 8.1 5.6 − 0.9 − 0.9 − 0.1
1999
2000
− 2.7
− 0.2
− 0.2
4.3
2.6
3.8
3.1
N − 1.1
− 1.3
− 2.1
− 1.7
1.0
0.1
0.1
A
2001 2.6 4.1 1.7 0.2
2002 − 0.9 2.1 4.9 − 2.9 1.9 0.1
− 0.2 − 0.1
M
2003 0.6 0.2 0.4 0.9
2004 4.1 − 3.5 1.6 − 3.0 7.4 − 0.3
2005 1.7 − 1.1 − 1.0 0.3 1.3 0.1
2006 3.6 − 0.6 2.1 − 2.0 5.6 0.0
D

2007 10.1 0.7 1.5 − 0.9 11.0 0.0

2008 15.8 − 1.1 − 2.2 1.3 14.2 0.3
TE

2009 0.8 6.6 8.3 − 3.3 4.1 0.0

2010 6.6 0.1 − 2.4 2.1 4.4 0.1
2011 11.0 1.0 − 5.0 4.9 5.8 0.3
EP

2012 2.9 4.7 0.5 2.1 0.8 0.0

2013 2.6 4.6 1.8 1.0 1.4 0.2
2014 − 0.1 3.9 2.4 0.2 − 0.5 0.2
2015 − 2.8 6.7 9.6 − 3.9 0.9 0.2
CC

Annual growth rate, %

1996-2004 0.4 2.4 3.1 − 1.4 1.8 0.0
2005-2015 4.6 2.3 1.3 0.1 4.4 0.1
A

1996-2015 2.7 2.3 2.1 − 0.6 3.2 0.1

Source: Appendix B (C1-3 and U1-2) and author’s calculations.

32
 Table 6

Sectoral TFP Growth: China and the U.S.

China U.S.

All All
Period Sectors Tradables Nontradables Sectors Tradables Nontradables

PT
TFP index, annual growth rate, %

1996-2004 3.7 4.7 2.1 1.8 4.5 1.1

RI
2005-2015 3.6 5.9 1.3 0.6 1.2 0.5
1996-2015 3.7 5.4 1.7 1.1 2.6 0.8

Source: Appendix B (C1, C3-7, and U1-6) and author’s calculations.

SC
U
N
A
M
D
TE
EP
CC
A

33
 PT
RI
SC
Table 7

Eq. (7) in Percentage Points

U
LHS RHS

N
Real

A
Appreciation
Relative Price of Nontradables in Tradables Error

M
Real
Exchange Sectoral Productivity Growth Gap Short-run
Rate (Balassa-Samuelson) Effect Demand-side Effect
Appreciation
ED
China U.S. China U.S.
Period ˆ 
ˆ* III LHS
 P  E  P  AˆT  Aˆ N  
AˆT*  Aˆ N*  Ia  IIa Ib IIb Ib  IIb 
PT  Eˆ  PˆT*
ˆ   RHS
PT

Annual growth rate, %

1996-2004 0.4 2.5 3.3 ‒ 2.9 0.2 ‒ 1.3 1.5 1.8 0.0
‒ 0.8 − 1.1
E

2005-2015 4.6 4.5 0.6 1.2 0.3 4.4 0.1

1996-2015 2.7 3.6 1.8 ‒ 0.7 ‒ 0.3 ‒ 0.4 0.1 3.2 0.1
CC

Source: Appendix B (C1-7 and U1-6) and author’s calculations.

A

34
 Table 8

̂𝑇∗ )
̂𝑇 − 𝐸̂ − 𝑃
China’s Real Exchange Rate Appreciation in Tradables (𝑃

Agriculture’s
Manufacturing Value Weight,
Period All Tradables and Mining Agriculture Tradables

PT
Annual growth rate, % End year, %

̂𝑇 )
China (𝑃
1996-2004 1.1 0.5 2.8 25.7

RI
2005-2015 2.5 2.0 5.7 22.1
1996-2015 1.9 1.3 4.4

SC
̂𝑇∗ )
U.S. (𝑃
1996-2004 − 0.6 − 0.7 − 0.3 7.4
2005-2015 0.8 0.8 0.2 7.3
− 0.0

U
1996-2015 0.1 0.2

Nominal exchange rate (𝐸̂ )

1996-2004
2005-2015
− 0.1
− 2.6
N
A
1996-2015 − 1.5
M

̂𝑇 − 𝐸̂ − 𝑃
Real appreciation in tradables (𝑃 ̂𝑇∗ )
1996-2004 1.8 1.3 3.3
2005-2015 4.4 3.8 8.2
D

1996-2015 3.2 2.7 5.9

Source: Appendix B (C1-3 and U1-2) and author’s calculations.

TE
EP
CC
A

35
 Figure 1

Chinese Yuan Real (RER) and Nominal (1/E) Exchange Rates, 1995 = 100

PT
RI
SC
U
N
A
M

Note. The nominal exchange rate (1/E) is the number of U.S. dollars per yuan indexed to the 1995 level.
D
TE
EP
CC
A

36