Understanding China's economic performance: Gaining insight from the Balassa-Samuelson hypothesis

Date of Completion

January 2007


Economics, General




This study assesses Chinese economic performance through the lens of China's real exchange rate movement over the past half-century. First, we examine when the Balassa-Samuelson relationship emerges in China. Second, we identify underlying factors leading to the emergence of the Balassa-Samuelson relationship. Third, we explore channels through which China's real exchange rate responds to the twin processes of China's transition from planned to market-orientation and emergence as a modern developing economy. ^ The analysis builds from a simulation of a calibrated model economy built from Chinese data. The model results show rising income is followed by real exchange rate appreciation, confirming emergence of the Balassa-Samuelson relationship. ^ A series of comparative static analyses identify rising total factor productivity, especially in the secondary sector, as the driving force behind the changing behavior of China's real exchange rate. Our experiments reveal rising productivity in both tradable and non-tradable sectors, with wage growth in the non-tradable sector, driving changes in the real exchange rate behavior. This result contrasts with the pattern Balassa-Samuelson anticipates: tradable productivity-led real appreciation. The implication is that the Chinese economy has outgrown its pre-reform focus on heavy-industry. China has moved to a more balanced development path between agriculture, industry, and service. ^ The results of the model economy suggest the following. First, it reveals the importance of rising productivity to sustain China's long run growth. Second, high wage growth in the non-tradable sector—especially in services—argues that China lacks sufficient skilled labor. To sustain its growth, China needs a better balance in physical and human capital investments. Third, Chinese growth currently relies heavily on the export sector, but assembling products puts China in the lowest segment of the value chain in the design-production-marketing process. Surplus labor with low skills does not confer on China competitive advantages in trade relations with the world. The large share of unskilled workers with low productivity in China's labor force makes it difficult to climb up the value chain. Given the current structure of the economy, this analysis argues for a moderate currency appreciation to accompany enhanced human capital investments as the reform and transition proceed. ^