The economic and social effects of real exchange rate. Evidence from the Chinese provinces

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1 The economic and social effects of real exchange rate Evidence from the Chinese provinces Ping HUA Clermont Université, CNRS, Université d'auvergne, Centre d'etudes et de Recherches sur le Développement International, BP 10448, F CLERMONT-FERRAND, France Tel : P.Hua@u-clermont1.fr for «INTERNATIONAL CONFERENCE ON SOCIAL COHESION AND DEVELOPMENT January 2011, Paris, France OECD Development Centre, with the financial support of Fundación Internacional y para Iberoamérica de Administración y Políticas Públicas (FIIAPP) Abstract Real exchange rate exerts different economic and social effects. If a real appreciation exerts positive effects on economic growth by exerting pressure on efficiency improvement and technological progress via workers motivation, education and capital intensity, it exercises negative effects by deteriorating the international competitiveness in tradable sector and thus by destructing employment. An econometric model is estimated by using the GMM system estimation approach and panel data for the 29 Chinese provinces and over the period from 1987 to The results show that the real exchange rate appreciation had a negative effect on the economic growth, higher in coastal than in inland provinces, contributing to a minimizing of the gap of GDP per capita between two kinds of the provinces. They show moreover that the real exchange rate appreciation acted negative effects on employment. Key words: China, economic growth, real exchange rate. 1

2 1. Introduction Since several years, China suffers more and more from international pressure in favour of the renminbi revaluation. However, the Chinese government has not surrendered to this insistent pressure because of the increased numbers of social unrests. Recently the primary minister Wen argued that forcing Beijing to revalue its currency would lead to a disaster for the world, because many of exporting companies would have to close down, migrant workers would have to return to their villages. If China saw social and economic turbulence, then it would be a disaster for the world. The worries of the Chinese government are comprehensive because an important empirical literature on export-led growth 1 found the negative impact of real exchange rate overvaluation on per capita growth rates; and this is particularly true for developing countries: the more overvalued the currency, the lower the per capita growth rate. Dollar (1992) and Benaroya and Janci (1999) argue that the relative undervaluation of the Asian currencies compared with those in Latin America and Africa explained the higher growth in Asian region. Hausmann et al. (2005) showed that real exchange rate depreciation is one of the factors associated with the growth acceleration. Eichengreen (2008) argues that a more depreciated real exchange rate together with weak exchange rate volatility favours growth process. Rodrik (2008) and Berg and Miao (2010) argues that not only are overvaluations bad but undervaluation is good for growth, particularly in developing countries. MacDonald and Vieira (2010) found that a more depreciated (appreciated) real exchange rate helps (harms) long-run growth especially for developing and emerging countries. The worries of the Chinese government are all the more comprehensive that the literature emphasizes that the main channel through which real exchange rate exerts on growth is the size of the tradable sector (especially industry), particularly for developing 1 The real exchange rate does not normally feature in economic growth models. 2

3 countries. As the tradable sector suffers disproportionately from the institutional and market failures in developing countries, the depreciation of real exchange rate increases the relative profitability of investing in tradables, and acts in second-best fashion to alleviate the economic cost of these distortions; and inversely (Rodrik, 2008). The existing literature is mostly based on the data of cross countries. It does not allow incorporating the special characters of each country and thus analysing the precise channels through which real exchange rate acts on economic growth 2. China provides an interesting country case study. China s economic growth has increased very rapidly since the beginning of its transition towards a market economy in The annual growth rate of the real GDP per capita (2000=100) was on average 9.4 % from 1979 to 2009, 3 contributing significantly to the reduction of global income poverty by lifting over 200 million people out of $1 per day poverty in the past three decades (World Bank, 2009). It is higher starting from 1994, passing from 8.0 % per year over the period to 10.7 % over the period. The speeding up of the economic growth is different according to the Chinese provinces 4. It is 2 Few papers identified the precise channels through which the growth effect of real exchange rate is generated. Rodrik (2008) explained that one channel is the size of the tradable sector (especially industry). Montiel and Servén (2009) show that saving is unlikely the mechanism through which the real exchange rate affects growth. 3 See figure 3 in section China is composed of 22 provinces (Hebei, Liaoning, Jiangsu, Zhejiang, Fujian, Shangdong, Guangdong, Hainan, Shanxi, Jilin, Heilongjiang, Henan, Anhui, Hubei, Hunan, Jiangxi, Gansu, Shaanxi, Sichuan, Guizhou, Yunnan et Qinghai), four autonomous municipalities under the direct control of central government (Beijing, Tianjin, Shanghai and Chongqing) and five autonomous regions (Guangxi, Inner Mongolia, Ningxia, Xinjiang and Tibet). In our econometric analysis, the autonomous region of Tibet is absent short of statistics, the statistics of Chongqing, created in 1997, are included into those of Sichuan, which lead to restrain 29 provinces in a large conception in terms of "province". 3

4 more pronounced in inland provinces 5 with its annual average growth rate passed from 7.6% to 9.98% than in costal provinces 6 (from 9.3% to 10.1%). The growth acceleration since 1994 has been accompanied by a reversal of the exchange rate policy of China. After a long period during which the Chinese government has systematically devalued the renminbi vis-à-vis the dollar, in 1994 it decided to stabilize and in 2005 to progressively revalue it. This policy led to a depreciation of real effective exchange rate of the Chinese currency against the currencies of its trade partners during the first period, especially strong from 1990 to 1993, and an appreciation during the period from 1994 to 1998, and in 2001, 2008 and It is therefore interesting to investigate the role of the real exchange rate in this growth acceleration, stronger in inland provinces than in coastal provinces. Has the appreciation of the real exchange rate contributed to speeding up or slow down the growth acceleration in China, and inversely? Is this contribution different in the two kinds of the provinces? No study, to our knowledge, analysed yet the growth impact of the real exchange rate in China. Most of the studies on China s exchange rate policy analysed the misalignment of the renminbi (see Cline and Williamson, 2007 for a review); while a few studies analysed the effects of real exchange rate in real economy 8. The objective of this study is to analyse the 5 Inland provinces, eighteen in total, are: Shanxi, Jilin, Heilongjiang, Henan, Anhui, Hubei, Hunan, Jiangxi, Gansu, Shaanxi, Sichuan, Guizhou, Yunnan, Qinghai, Guangxi, Inner Mongolia, Ningxia and Xinjiang. 6 Coastal provinces, eleven in total, are: Beijing, Tianjin, Hebei, Liaoning, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong, Guangdong and Hainan. 7 See figure 2 in section Guillaumont Jeanneney and Hua (1996) and Hua (1996) showed positive effects of the real depreciation on China s exports. If the real appreciation decreased China s manufacturing employment (Hua, 2007), it decreased however the urban-rural and coastal-inland income inequality (Guillaumont Jeanneney and Hua, 2001) and boosting labour productivity (Guillaumont Jeanneney and Hua, 2010). 4

5 impact of real exchange rate on economic growth by investigating the precise transmission channels through which real exchange rate acts on growth. The issue of the possible impact of the real exchange rate on economic growth is an important one at this time a widespread currency war 9 is in prospect (Cline and Williamson, 2010); and the main objective of the Chinese government is to keep a high growth rate to create enough employment. The rest of this study is the following. In section 2, after the presentation of the evolution of China s exchange rate policy and of its economic growth, a statistical analysis shows a negative relationship between real exchange rate and the economic growth in China, stronger in coastal than in inland provinces. To understand this negative relationship, we present in section 3 how theoretically real exchange rate variations may exert (positively or negatively) multiple effects on economic growth. We identify three kinds of transmission channels through which real exchange rate influences economic growth: 1) input factors (employment, education and capital intensity) channels, 2) tradable sector channels (exports, FDI and industrial sector) and 3) efficiency channels. We explain that if a real appreciation exerts positive effects on economic growth by acting pressure on efficiency improvement and technological progress via workers motivation, education and capital intensity (rarely studied in the literature), it exerts negative effects by deteriorating the international competitiveness in tradable sector and by destructing employment (traditional argument). Consequently, the sign of the total effects of real exchange rate on economic growth is theoretically ambiguous and only an empirical analysis can reveal it. From this theoretical analysis we draw our estimating strategy. We define a function of economic growth which includes the real effective exchange rate beside more traditional factors which are themselves supposed to depend on the real exchange rate. In section 4, we estimate these functions by using a panel data which combine the 9 Guido Mantega, Financial Minister of Brazil, said We re in the midst of an international currency war, a general weakening of currency. 5

6 temporal dimension represented by annual data and the spatial data represented by the 29 Chinese provinces. In conclusion we draw some policy implications. 2. Real exchange rate and economic growth in China: the evidence of styled facts A descriptive approach of the evolution of China s exchange rate policy and of its economic growth suggests that the real exchange rate appreciation acts a negative impact on the economic growth, higher in coastal provinces than in inland provinces; and that the reversal of the exchange rate policy from currency depreciation to appreciation contributed to slow down the acceleration of economic growth more sensible in coastal than in inland provinces China s nominal exchange rate policy and the evolution of its real exchange rate China s exchange rate regime China s exchange rate regime is the fruit of a long evolution from two exchange rates to a unique rate which remains tightly managed until now. During the first years of 1980s, the exchange rate policy played a little role, because foreign trade was largely planned. It is only since 1984 that national foreign trade societies should take international prices into account to fix the sale price of imported goods and the purchasing price of exported goods (Guillaumont Jeanneney and Hua, 1996). From 1981 to 1993 the export societies have benefited from a foreign exchange retention system. They could sell some of their foreign exchanges obtained from exports at an administrated rate of the dollar higher than the official rate (simultaneously applied to planned importations and capital transactions). At the end of 1986, the administrated rate became a swap market rate which was determined in the foreign exchange market, even still under the 6

7 State s control. The export societies continued to deliver one part of the foreign currencies obtained from their exports to the People s Bank of China at the official rate, and sold another part, proportional to their retention quota, to the foreign exchange market at the swap rate. The foreign exchange retention rate has progressively increased up to 80% in 1993, so well that the swap rate became the principal rate for trade transactions at this time. From 1985 to 1993, the Chinese government devalued the two exchange rates against the dollar several times. These devaluations were not realized simultaneously most of the time. Often, one of the two rates stayed stable and played the role of a monetary anchor. It contributed thus to slow down inflation, and favoured the real depreciation of exchange rate (Guillaumont Jeanneney and Hua, 1996, Guérineau and Guillaumont Jeanneney 2000). The nominal and real depreciations vis-à-vis the dollar were in fact large (respectively 53 % and 37% for the official rate over the period from 1990 to 1993) (figure 1). On 1 st January 1994, China radically changed its policy. The double exchange rate system was suppressed; the swap rate became the unique official rate for all transactions. The last one was officially a managed floating, but in fact strictly pegged to the dollar and maintained stable since then. On 21 July 2005, the Chinese authorities decide to revalue the renminbi of 2.1% vis-à-vis the dollar, to switch from the dollar peg to a basket 10, and to allow the currency to float more freely 11. Since this date, the renminbi was progressively revalued against the dollar. From 2005 to 2009 the renminbi appreciated of 17% in terms of dollars and its real bilateral rate appreciated of 18 % (Figure 1). The Chinese authorities have undertaken several reforms to improve the functioning of the exchange market permitting some flexibility in the short run, but the rate until now remains tightly managed. 10 The basket of currencies is undefined (like Singapore does). The four main currencies in the basket are the US dollar, the euro, the yen and the won. 11 The US dollar against the RMB is allowed to float within a band of 0.3 percent around precedent daily rate. 7

8 The evolution of the real effective exchange rate of China as a whole Real exchange rate conditions the international competitiveness of a country relative to its trade partners, and exerts multiple effects on real economy. It is the key variable in this study. It can be approximated by a real effective exchange rate index, calculated here as the product of China s nominal effective exchange rate (weighted average of the renminbi exchange rates against the currencies of the main foreign trade partners of China) and the ratio of consumer price index of China to the weighted average consumer price index of the same main trade partners. According to this definition, a rise of the real effective exchange rate corresponds to an appreciation of the Chinese currency. The nominal effective exchange rate depends on the relative variations of the different bilateral exchange rates of the renminbi against the currencies of the main foreign trade partners and therefore it evolved differently from the bilateral exchange rate against the dollar. The evolution of the real effective exchange rate of the renminbi is different from that of the nominal one, due to the price differential between China and its partners which was positive during the depreciation period. From 1987 to 1993, the real effective exchange rate decreased at an annual rate of 7 % on average with a total depreciation of 43% during the seven years 12. The drop was particularly strong in 1993 (17 %) 13. From 1994 to 1998 the real effective exchange rate appreciated strongly (at an annual rate of 9% on average, i.e. 52 % during the whole period of these five years). Since then, it experienced some weak depreciation as the nominal one except for the year 2001, when it appreciated of 6.4%. The real exchange rate appreciated 12 From 1979 to 1993, the real effective exchange rate decreased at an annual rate of 7.7 % on average per year with a total deprecation of 72% during fifteen years. 13 The drop was even more important in 1981 (44%) when the foreign exchange retention system and the double exchange rate system were introduced and 1986 (29%) when the administrated rate became a swap market rate. 8

9 again in 2008 (12%) and in 2009 (6%) (figure 2). This led a total real appreciation of 62.5% during the period from 1994 to 2009, i.e. at an annual rate of 1.59% on average. The evolution of the real effective exchange rate of the Chinese provinces The change in real effective exchange rate varied from one province to others in China. This disparity results from two factors (Guillaumont Jeanneney and Hua, 2001, 2002). The first one is the diversity of their foreign trade partners, as each province tends to trade more with its border countries 14. Therefore the weighting of the foreign currencies is different. The second factor is a considerable difference between provinces inflation 15. From 1987 to 2009, average annual rate of inflation has ranged from 5.7% in Henan province to 8.0% in Beijing municipality. These differences are themselves due to several reasons: the differences in Chinese provinces production and consumption patterns and external trade, the fiscal and monetary policies largely decentralised in China and very different from one province to another (Guillaumont Jeanneney and Hua, 2004). From 1987 to 1993, the annual average depreciation of the real effective exchange rate in Chinese provinces varied from 6.9% for Guizhou to 2.8% for Beijing, while during the period from 1994 to 2008, the average appreciation varied from 1.14 % for Guangdong to 3 % for Qinghai (Table 1) 16. The real depreciation during the period from 1987 to 1993 as well as the real appreciation during the recent period from 1994 to 2008 has been slightly lower in the 14 Guillaumont Jeanneney and Hua (2002) reported in this same review the share of imports of each province from the 20 main partners (see appendix A, pages from 153 to 156). 15 as illustrated in the figure reported in Guillaumont Jeanneney and Hua (2002, page 135). 16 One exception concerns Yunnan which did not experience an appreciation of its real exchange rate during the recent period, mainly due to inflation less high than that of Myanmar as its 4 th most important partner; the share of Myanmar in the total import of the Yunnan province is equal to 6.8% and the inflation was 1528 % in Myanmar over the period from 1994 to

10 coastal provinces than in the inland provinces: the annual average rate of depreciation was 4.41 % in coastal provinces against 4.84% in inland provinces and the real appreciation was 1.77% in the coastal provinces against 2.01% in the inland provinces. According to the impact of the real exchange rate upon economic growth, these differences might have contributed to increase or decrease the growth gap between the two kinds of provinces. 2.2 Economic growth in China as a whole and in the provinces The evolution of the economic growth in China as a whole The economic growth is calculated in this study as the ratio between the GDP expressed in 2000 constant prices and total population. Figure 3 shows the evolution of economic growth in China as a whole since 1978, the year which marked the beginning of China s economic reforms inside the country and of its openness policy to the outside. The economic growth in China increased dramatically, passing from yuans per capita in 1978 to yuans in It is multiplied by sixteen over the 31 years, which corresponds to an annual average growth of 9.4 %. From 1987 to 2009, the economic growth was weak only in two years (2.8% in 1989 and 3.7% in 1990); while during the other years it was at least 7.8%. The economic growth slowdown during these two years was probably due to the break in the reforms after the student movement in Tiananmen Square. China s economic growth accelerated from 8.01% during the period to 10.68% during the period from The evolution of the economic growth in the Chinese provinces The economic growth did not increase at the same rate in the different Chinese provinces as in the different periods. The annual average rate of economic growth varied from 10

11 7 % for Qinghai to 12 % for Zhejiang during the period from 1979 to The economic growth varied from 5.5% for Qinghai to 12.1% for Guangdong during the period from 1987 to 1993 and between 7.3% for Xinjiang and 14% for Inner Mongolia from 1994 to 2009 (table 1). All the Chinese provinces (except Fujian, Guangdong, Hainan and Xinjiang) have experienced an acceleration of economic growth since 1994, but at a different rate (table 1). The speeding up of the economic growth is more pronounced in inland provinces with its annual average growth rate passed from 7.6% during the period to 9.98% during the period than in costal provinces (from 9.3% to 10.1%). The economic growth was more than doubled in three inland provinces (Anhui, Qinghai and Inner Mongolia) and in one coastal province (Tianjin) because their economic growth is particularly weak. On the contrary, among the four provinces which did not meet the growth acceleration during the recent period, Guangdong and Hainan suffered from the strong deceleration of the economic growth which passed respectively from 13% to 9.7 % and from 13% to 7.8%. This provincial discrepancy of economic growth is not surprising as the factors of economic growth have not evolved similarly in the different provinces and in the different periods. In a general way, we observe a higher economic growth in coastal than in inland provinces during the period of the real depreciation, while this high gap of economic growth diminished strongly during the second period of the real appreciation (table 1). The coastal provinces benefit from many coastal advantages relative to tradable sector: they have a dynamic industrial sector producing more light industrial goods and largely oriented towards outside; receive more FDI, and suffer from less constraint of credits and foreign exchanges in order to import machines and equipments 17 and have more private industrial enterprises and 17 Fleisher and Chen (1997) showed that the weak presence of foreign direct investment in the inland provinces contributed to explain the productivity gap relative to coastal provinces. 11

12 attract more educated labour. The real depreciation may have stimulated these coastal advantages, leading a higher economic growth in coastal than in inland provinces; while the real appreciation has probably exerted negative effects on the coastal advantages, and may have slowed down the growth more important in coastal than in inland provinces. Consequently, it is expected that the growth elasticity of real exchange rate is higher in coastal than in inland provinces Real exchange rate and growth: the evidence of stylized facts The figure 4 presents the relationship between the real exchange rate appreciation and economic growth in China over the period from to We observe a negative relationship between the real appreciation and the growth rate of real GDP per capita. During the years when the renminbi appreciated, the economic growth slowed down. Inversely, during the years when the renminbi depreciated, the economic growth increased. The figure 5 shows the relationship between the real effective exchange rate and real GDP per capita on average over the period from 1987 to 2008 for the Chinese provinces. As waited, we observe that the negative impact of real exchange rate appreciation on the real GDP per capita is stronger in coastal provinces than in inland provinces. The strong depreciation during the period from 1987 to 1993 may have stimulated the economic growth more importantly in coastal provinces than in inland provinces; while during the recent period from 1994 to 2009, the real appreciation may have slowed down the economic growth stronger in coastal provinces than in inland provinces. Consequently, the real depreciation of the renminbi may have contributed to an increasing gap of economic growth between the two categories of the provinces (at an annual average rate of 9.3% for coastal provinces and 6.4% for inland provinces); while the real appreciation may have slowed down the real GDP per 18 when the swap market rate replaced the administrated one. 12

13 capita divergence between the two categories of the provinces (respectively 10.8% and 9.98%). This satisfying evolution might be due to the reversal of the exchange rate policy in 1994, all the more that the depreciation and the appreciation of the real exchange rate are larger in inland provinces than in coastal provinces (Table 1). The fact that the real appreciation of the renminbi exchange rate slowed down the economic growth acceleration particularly marked in coastal provinces and inversely, incites us to identify the transmission channels through which the real exchange rate could have been acting on economic growth in the two categories of the Chinese provinces during the last twenty years. This is the objective of the next section. 3. Why has real exchange rate appreciation affected negatively economic growth in China: a theoretical analysis The factors that could affect economic growth are numerous in an economy in transition towards a market economy such as China, where economic policies and productive structures have dramatically changed. A plethora of literature argues that China s economic growth can be explained by the rapid expansion of the industry (Lin and Liu, 2008), the external openness with the development of manufactured exports (Fu and Balasubramanyam, 2005; Kraay, 2006) and foreign direct investments 1 and the promotion of the private sector in disfavour of the sector of state-owned enterprises (SOEs) (Jefferson and Su, 2006 ; Dougherty et al., 2007). The role of employment and human capital is generally recognized as positive factors of growth (Fleisher and Chen, 1997; Zhu, 1998; Wang and Yao, 2003). All these factors may be potentially affected by real exchange rate, and thus may be transmission channels through which its growth impact passes. Finally, the real appreciation may exert a direct action on work efficiency by modifying the real remuneration of workers and 13

14 exacerbating competition (Guillaumont Jeanneney and Hua, 2010). We explain that if a real appreciation exerts positive effects on economic growth by acting pressure on efficiency improvement and technological progress via workers motivation, education and capital intensity, it exerts negative effects by deteriorating the international competitiveness in tradable sector and by destructing employment. Consequently, the sign of the total effects of real exchange rate on economic growth is theoretically ambiguous and only an empirical analysis can reveal it. From this theoretical analysis we draw our estimating strategy. We define a function of economic growth which includes the real effective exchange rate beside the above mentioned factors which are themselves supposed to depend on the real exchange rate Real exchange rate and the size of tradable sector Real exchange rate measures the relative price of domestic goods relative to foreign ones and is an indicator of international competitiveness of a country. The most traditional argument in favour of a negative effect of real appreciation upon economic growth is based on the assumption that real exchange rate appreciation deteriorates the competitiveness of enterprises vis-à-vis their foreign competitors and therefore decreases exports. This deterioration diminishes thus the profits of the exports sector (which roughly means industry of manufactured goods in the case of China) in favour of services and agriculture, largely protected from foreign competition (Guillaumont Jeanneney and Hua, 2002). It decreases industrial self-financing and the will to invest in the industrial sector, and more generally in the tradable good sector. If this last one is the most efficient and innovating, real appreciation may act negatively on growth, beyond its impact on mainly exporting firms. Real appreciation is particularly bad for growth in developing countries because it does not allow promoting the 14

15 small and inefficient tradable sector, which suffers disproportionately from the institutional and market failures (Rodrik, 2008). The negative effect of real appreciation on the growth also channels through the decrease of foreign direct investments (FDI). In China, as in other developing countries, foreign investments are concentrated in the sector of tradable goods. Foreign firms bring technological improvements and their know-how to China. This positive action occurs through the creation of foreign companies or joint-ventures that are more productive than domestic firms, suppliers or customers of the foreign enterprises (Sun, 1998). Hale and Long (2007) and Liu (2008) explain that FDI diffusion or spill over effects are not necessarily positive. However many studies show that this positive effect exists in China, in particular in the manufactured sector where the main part of foreign direct investments go 19. Finally, as the stated-owned enterprises are mainly in the heavy industry and the public services and, being protected from outside competition, they mainly produce nontradable goods, real appreciation favours them. The private, collective and foreign firms are freer in workers hiring and in their management than state-owned enterprises and generally more productive. Henceforth, real appreciation exerts a negative impact on growth by increasing the relative importance of state-owned enterprises. In China, the tradable sector is particularly concentrated in coastal provinces, whose exports represented 91% of the total exports in As the size of tradable sector is much important in coastal provinces than in inland provinces, it is expected that the negative effect 19 Sun, Hone and Doucouliagos (1999) have used data relative to 28 manufactured sectors in the 29 Chinese provinces in 1995 and have shown that trade and financial openness is a factor of industry efficiency. Later, Li et al. (2001) and Buckley et al. (2002) have evidenced the diffusion effect of FDI to Chinese manufactured enterprises thanks to data of the industrial census, and Liu et al. (2001) to electronic enterprises with data relative to 41 sectors in 1996 and FDI spill over has also been captured thanks to data relative to the performance of Chinese towns in 1990 and 2002 (Madariaga and Poncet, 2007). 15

16 of real appreciation is more sensibly in coastal provinces than in inland provinces; and inversely Real exchange rate and workers effort A real exchange rate appreciation increases real remuneration of non-qualified work expressed in tradable goods 20. We suppose that this increase induces an efficiency improvement of workers in a country where the wages of unskilled workers are still low (Guillaumont and Guillaumont Jeanneney, 1992). As early as 1957, Leibenstein stressed that in developing countries a labour remuneration that is too weak might spoil workers health and their working capacity and showed that the motivation of workers acts on the efficiency, what he called the X-efficiency (Leibenstein, 1957, 1966). This hypothesis appears relevant in the case of China. Although the proportion of the poor population (with an income no more than one dollar a day 21 ) has been decreasing rapidly since 1978 (still 16.6% in 2001, it passed to 10.3% in 2004, and to 4% in 2007), China has the highest number of poor population in the world after India (World Bank, 2009). The population just over the line of poverty remains highly vulnerable, notably in inland provinces where the wages are significantly lower than in coastal provinces. The impact of a real appreciation on workers effort could be thus stronger in inland provinces than in coastal ones. Second, a real appreciation could push firms to improve their technical efficiency in a context of monopoly or collusive oligopoly (Krugman, 1989). The argument is the following: managers only benefit from a part of the profit induced by a better management or a stronger 20 In terms of tradable goods and in terms of consumption goods which include the two kinds of goods. 21 Exactly 2.15 and 1.08 dollars by measuring the expenditures in 1993 international prices (World Bank World Development Indicators, 2004). 16

17 effort since a part of the profit goes to the owners of the enterprise. In the case of monopoly, managers do not choose the exertion which maximizes the profit for such reasons as a preference for leisure over work, involvement in seeking out other profitable opportunities, and the power and satisfaction gained from having an excess number of employees (Baldwin, 1995). As Marshall said, the better profit of a monopoly is a quiet life. In a situation of oligopoly (due to foreign competitors and competitors localised in other provinces), the managers will choose a higher level of effort by eliminating excess labour or possibly by introducing labour-saving techniques that were not fully exploited prior to the competitive disturbance. They do so not only because this behaviour may increase the profit in the short run, but also because the decrease of costs dissuades competitors from entering into the market and thus avoids a fall in the price. Due to this strategic yield, there exists an additional benefit induced by the effort which may push management effort near to its optimum 22. In a more general manner, in any market structure, the intensification of foreign competition due to currency real appreciation is favourable to the productivity of manufactured firms as some of them are obliged to close the less performing factories or even to disappear; it is a kind of Schumpeterian creative destruction benefiting to the most performing enterprises. This argument is realistic for China: under the pressure of the renminbi appreciation since 1994, and notably since China s adhesion into the WTO in 2001, the Chinese firms have been more and more exposed under high foreign competition and a large number of firms (notably public ones) were obliged to reform their management or to be closed. 22 Voir Krugman (1989) p

18 Besides the above direct favourable impact of a currency appreciation on workers and managers efficiency, a real appreciation may affect economic growth by acting positively on the education level and the capital labour ratio, but negatively on employment Real exchange rate, capital intensity, human capital and employment A real appreciation reduces the relative cost of imported capital goods and increases wages relative to capital price. It induces a more capitalistic production, encourages technological innovations (Leung and Yuen, 2005) and thus increases growth. It increases the real remuneration of workers expressed in tradable goods. We may suppose that the rise in wages incites young people to increase their education level and that it slows down the emigration of the most skilled workers (Harris, 2001). China has endured a significant brain drain and we observe in present time some Chinese educated workers coming back thanks to a better remuneration. The improvement of the education level of workers is recognised as being an important factor of economic growth (Fleisher and Chen, 1997; Hua, 2005; Liu and Li, 2006). Finally, a real appreciation of exchange rate acts on employment via the relative cost modification of imported inputs and workers, via export activities and via the efficiency in the use of labour. Firstly, it decreases the cost of imported inputs and leads to higher real wages expressed in tradable goods. This leads the switching of factors from workers to imported inputs, and is unfavourable to employment by increasing labour productivity. Secondarily, a real appreciation decreases the competitiveness of national societies, and thus the tradable activities. It is unfavourable to employment in tradable sector. Thirdly, a real appreciation exerts pressure on efficiency improvement by increasing international competition and real wages, and thus a favourable to employment. Using the panel data of the 29 Chinese 18

19 provinces for the period , Hua (2007) showed statistically significant negative effects of the real appreciation of the renminbi on manufacturing employment. Table 2 summarizes the multiple effects that the real exchange rate variation is supposed to exert on economic growth in China. It distinguishes the effects of real exchange rate variations on the workers efforts (here named direct effect) from the effects passing through the channels relative to the size of tradable sector and to the production factors, which are themselves affected by the real exchange rate (here called indirect effects). Three effects of the rise of the real exchange rate (or of its appreciation) on the economic growth are positive (work effort, capital/labour ratio, education level), while the five (exports, foreign direct investments, employment, relative importance of industrial production and of stateowned enterprises) are negative (cf. the third column of the table 2). The total action of the real appreciation of exchange rate on economic growth is therefore theoretically uncertain. The sole econometric estimation may reveal it. 3.3 The model to be estimated From the above theoretical analysis, we estimate an economic growth function in which we introduce the real exchange rate, together with other explanatory variables of economic growth such as capital intensity, employment ratio, education, exports, industry, FDI and public investments. We also introduce the level of a real GDP per capita lagged one period to test an eventual convergence effect of economic growth between provinces. Moreover, we suppose that the direct efficiency effect of the real exchange rate which exerts through the workers effort is all the more relevant that the workers are poor. Since the proportion of poor workers is higher in inland provinces than in coastal provinces, we test whether these direct effects are conditional to the geographical position of provinces, by 19

20 introducing a dummy variable for coastal provinces and its interaction term with the real exchange rate. As all the control variables are added into the equation, the coefficient of the real exchange rate measures only the effects that we do not capture by the intermediary variables and notably the direct effects on work effort, according to the second line of the table 2. ln yit = ln yit ln yit 1 = a0 + a1 ln REERit + a2 ln KLit + a3 ln EM it + a4 ln EDUit + a5 ln X it + a6 + a7 ln FIit + a8 ln SOEit + a9 ln yit 1 + a10c + a11 ln REERit * C + η i + γ t + εit ln IN it Which can be in return written as following ln yit = a0 + a1 ln REERit + a2 ln KLit + a3 ln EM it + a4 ln EDUit + a5 ln X it + a6 + a7 ln FIit + a8 ln SOEit + (1 + a9)ln yit 1 + a10c + a11 ln REERit * C + η i + γ t + εit ln IN it Where y :per capital real GDP, REER: real exchange rate, KL : capital intensity, EM: share of employment EDU : education level, X : export share, IN: share of industrial production, FI : contribution of foreign direct investments to gross formation of fixed capital, SOE: relative importance of state-owned enterprises, C: coastal provinces The variables, except for dummy one, are expressed in logarithms so that the coefficients represent elasticities. The disturbance term consists of an unobservable provincial fixed effect that is constant over time η i, an unobservable period effect that is common across provinces γ t and a component that varies across both provinces and periods which we assume 20

21 to be uncorrelated over timeε it. The expected elasticity signs of all variables in the equation are positive, except for that of public enterprises share and of the interaction term between the real exchange rate and the coastal dummy which are expected negative. The direct growth effect of real exchange rate is estimated by a 1 for inland provinces, and a 1 +a 11 for coastal provinces. In the second step, we look for the growth effects of the real exchange rate which exert indirectly via the other variables that we have supposed explaining the growth: capital intensity, employment, education, exports, industrial production, foreign direct investments and state-owned enterprises (according to the second part of Table 2, line 2 and column 2). With this aim in view, we must estimate the impact of the real exchange rate on these factors. We add a dummy variable, which is equal to 1 for coastal provinces, to capture their comparative advantages as we explained before. We estimate separately the following equations. KL it EM Edu it it = b + b ER + b C + η + γ + ε 0 1 it 2 i1 t1 it1 = c + c ER + c C + η + γ + ε 0 1 it 2 i2 t2 it 2 = d + d ER + d C + η + γ + ε 0 1 it 2 i3 t3 it3 (2) (3) (4) X it = e + e ER + e C + η + γ + ε 0 1 it 2 i4 t4 it4 (5) IN it = f + f ER + f C + η + γ + ε 0 1 it 2 i5 t5 it5 (6) FI it = g + g ER + g C + η + γ + ε 0 1 it 2 i6 t6 it6 (7) SOE = h + h ER + h C + η + γ + ε it 0 1 it 2 i7 t7 it7 (8) The expected elasticity signs of equations 2, 4 and 8 are positive, while the rest of equations are negative. We can then calculate the indirect effect of the real exchange rate on economic growth 21

22 as the sum of the products of economic growth elasticity relative to each intermediary variable multiplied by its corresponding elasticity relative to the real exchange rate (table 3). 4. The growth impact of real exchange rate in China: an econometric analysis We present successively variable calculation, estimation method and the results Estimation period and calculation of variables The panel estimation concerns the twenty-nine provinces and covers the period from 1987 to 2008, during which the real effective exchange rate either depreciated or appreciated (see figure 2). The panel is unbalanced, with some provinces having more observations than others. The means and standard deviations of the variables are provided in table 4, while their sources are given in annex 1. Per capita real GDP is calculated as real GDP (2000=100) divided by population. The real effective exchange rate indices of the Chinese provinces are calculated on the basis of year 2000=100, as the ratio of consumer price index of the considered province to the average consumer price index of its fifteen foreign trade partners 23 (defined by geographical import origins in ), all prices being converted into the same currency as following: REER j = 15 i= 1 ( NER ij Pj ) P i α i. where REER represents the real effective exchange rate of the renminbi, 23 We unfortunately had to eliminate several ex-soviet Union countries due to a lack of data on exchange rates. 24 This is the only year for which we obtained China s General Administration of Customs data on import origin for different provinces. We therefore suppose that each province kept the same partners throughout this period. We also used real effective exchange rates, supposing that the weights of each province are the same as national averages for China; this is not an ideal hypothesis given China s size and the specializations of each province, as confirmed by econometric results (not presented here). 22

23 NER ij is the nominal bilateral exchange rate of the renminbi in terms of currency of foreign partner i with i= P j corresponds to consumer price indices of the Chinese province j. P i corresponds to consumer price indices of the country i αi is the weight of each partner calculated as a relative share of the imports of the provinces j from its foreign partner i relative to the total of imports from its fifteen main partners in 1998, with α i = i= 1 Consequently, an increase of the real exchange rate corresponds to an appreciation of the Chinese currency or a decrease of the relative price of tradable goods. Given that from 1987 to 1993, China used two exchange rates, i.e. official rate and swap rate, the renminbidollar exchange rate is calculated for this period as a weighted average of these two exchange rates, taking part of imports financed by swap exchange market for weighting. The calculated weighted pre-1994 nominal exchange rate of the renminbi to the dollar is not equal for each province because swap rates differed between provinces. The data on provincial swap rates are available in Khor (1993). Although all the Chinese provinces shared the same single nominal exchange rate from 1994 on for the rest of the estimation period, their real effective exchange rates have evolved at different rates because provinces have different foreign trade partners and inflation rates. In fact, each province tends to trade more with its border countries, leading the diversity of their foreign trade partners. Therefore the weighting of the foreign currencies is different. The second factor is a considerable difference between provinces inflation due to the differences in Chinese provinces production and consumption patterns and external trade, the fiscal and monetary policies largely decentralised in China and very different from one province to another (Guillaumont Jeanneney and Hua, 2004). Capital intensity is the ratio of capital stock divided by the number of employees. We 23

24 use the inventory permanent method to calculate the capital stock 25, as KR + t= ( ) KRt 1 IRt, where KR and IR represent respectively the capital stock and the investment (i.e. gross fixed capital formation) in constant prices and the annual depreciation rate is supposed 5 % as in preceding papers (Wu, 2001; Lin and Liu, 2008 and Zheng and Hu, 2006). We suppose that the initial capital stock in 1965 is equal to the real investment that year. This hypothesis does not influence capital stock calculation since 1986, because all the capital stock in 1965 has been amortized in Since capital depreciation data is available since 1993 for each province, the capital stock over the period from is calculated as KRt = KRt 1 + IRt DRt, where DR represents real depreciations, which are equal to nominal depreciations deflated by the price index of the investment in fixed assets. Thus, the depreciations of capital are different for each province and for each year, while preceding studies supposed a depreciation rate of 5% for all the provinces and each year. The real gross fixed capital formation is deflated by two series of prices (100=2000), which are successively available: the price index of gross fixed capital formation, drawn from historical data of National Accounts, available until 1995, and the price index of investment in fixed assets available since 1992, in China Statistical Yearbook. The first series is used for the period from 1972 to 1992 and the second for the following years. This combination is not a drawback, as in the overlapping years the two price series differ only marginally, as observed also in Holz (2006, p. 8). 25 Holz (2006) and Chow (2006) present an interesting debate on capital stock estimates for China. Instead of using capital depreciation, Holz suggests evaluating the value of replacement with several complex but disputable conventions. Chow defends that subtracting depreciated capital instead of using replacement value allows one to take into account, not only equipment depreciation, but also quality deterioration and costs of maintenance and repair when the equipments are used beyond amortization period. We have followed traditional method as in Chow s paper and most of the studies. Holz does not calculate capital stock for the Chinese provinces. 24

25 Employment ratio is the share of employed population relative to total one. Education is calculated as the ratio of the total number of graduates from secondary and higher level education to total population. The education data for 1982, 1990 and 2000 are respectively obtained from the 4 th and 5 th Population Census of China. The data for other years is obtained from the annual sample survey on population changes. The exports are reported to GDP and foreign direct investments to gross fixed capital formation. The share of industrial production is calculated as the part of the secondary sector (except for construction) in the GDP. The share of state-owned enterprises is the ratio of their investment to the total investment of enterprises Econometric method The Levin-Lin-Chu panel unit root test is applied to all the variables. The results of these tests lead to reject the null hypothesis of non-stationarity (see table 4). The principal potential econometric problem is the endogeneity of explanatory variables, a difficulty that is met in all the estimations on macroeconomic data due to simultaneity bias (we recall the double causality of the real exchange rate and the growth), to measurement errors of variables which are a particularly serious problem in China, and to the risk of omitted variables. Moreover the introduction of the lagged dependent variable renders the OLS estimator biased and inconsistent, as the lagged dependent variable is correlated with the error term even in the absence of serial correlation betweenε it. As a precaution against the risk of simultaneity of the dependant and explanatory variables, we have lagged one year all these explanatory variables, i.e. real exchange rate and the other traditional determinants of economic growth, in the estimations. Moreover, we treated both the endogeneity problem and the problem of structural heterogeneity of the 25