Inflation in China is depreciating the Yuan

Over the most recently reported two months, the CPI-adjusted (inflation adjusted) real exchange rate of the yuan has been appreciating relative to the dollar at about a 13 percent annual rate. That would be enough to eliminate the estimated 20 to 40 percent undervaluation of the yuan in less than three.

Analysis from Edwin G. Dolan holds a Ph.D. in economics from Yale University and published at SeekingAlpha.

Using consumer prices to calculate real exchange rates has the advantage that the monthly CPI for both countries is available with a very short lag. However, many observers think that real exchange rates based on unit labor costs in manufacturing give a more accurate picture of competitiveness in international trade. Unit labor costs (ULC) take into account both changes in nominal wage rates and changes in labor productivity, and a focus on manufacturing excludes price and wage changes that affect only non-traded services. Unit labor cost data is not available as rapidly or in as much detail as consumer prices, but estimates from the World Bank suggest that Chinese unit labor costs rose at an annual rate of about 4 percent in the first three quarters of this year. Over the same period, they decreased at an annual rate of about 5 percent in United States, giving a 9 percent differential. Since the June thaw in Chinese exchange rate policy, the yuan has been appreciating at a nominal annual rate of about 6 percent. Adding nine to six suggests that the ULC-adjusted real exchange rate of the yuan has been appreciating at a 15 percent annual rate, even more rapidly than the CPI-adjusted rate.

The most likely outcome for China over the coming months is the use of all available policies in combination. Expect continued increases in interest rates and reserve requirements. Targeted, temporary price controls are also a possibility. Continued nominal appreciation of the yuan is a virtual certainty. There appear to be factions within the Chinese policy establishment that would even like a slightly faster pace of nominal appreciation. Used together, these tools may succeed in breaking the upward trend of Chinese inflation, but they are unlikely to fully erase the inflation differential with the United States.

As long Chinese inflation remains above the U.S. rate, the real exchange of the yuan will continue its steady appreciation relative to the dollar. Contrary to the political bluster heard from some quarters, appreciation of the yuan will not solve all the world’s problems. Over time, however, we can expect it to make a helpful contribution to easing some of the most acute global imbalances.

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