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1 The RMB Undervaluation Puzzle: An Input-Output Analysis * SSRN Working Paper # Available at: JEL F31 L51 D57 Abstract: The RMB undervaluation puzzle refers to two related facts: 1) that the RMB real exchange rate has been depreciating along with China s strong economic growth; 2) that most Western researchers agree that the RMB is seriously undervalued in recent years. We propose that this puzzle is mainly caused by an inter-regional race to the bottom in China, which reduces average input usage and labor cost, thus seriously depressing the general price and wage level through three types of price multiplier effects. We extend the standard input-output model to simulate the price-level effect of racing to the bottom in two key sectors (road transportation and coal mining), using actual input-output data. The results show that, quantitatively, our model can fully explain the RMB undervaluation puzzle. The implication is that in order for the RMB real exchange rate to reach and remain at a proper level, inter-regional race to the bottom in China must be effectively tackled, which entails a radical overhaul of China s economic system and the transition of its development model. Keywords: the RMB real exchange rate, race to the bottom, input-output model JEL classification: F31; L51; D57 * Tel.: ; Fax: ; address : tangxiang_pku@163.com

2 JEL F31 L51 D The Balassa- Samuelson model Balassa 1964 Samuelson 1964 / % enhanced-ppp

3 % Bosworth 2004 Coudert Couharde 2005 Frankel 2006 Subramanian 2010 Coudert Couharde 2005 Goldstein Lardy % 36%Cline Williamson 2007 Krugman 2009 Bergsten % 1/

4 ~30% 24~44% 30~50% 40~110% race to the bottom / Process and Production Methods PPMs Chan,

5 % 2008 Rosen Houser Midler I II III 2 {p 1, p 2, p 3, p 4 } 4 p w ω

6 w ω 2 I w p 1, p 2,, p n p II ω I I p p w w p 1, p 2,, p n I p p III ω ω ω w p ω ω w p ω 1% w p 4% 3% 1% = 4% 3% w p ω w p ω w p 1990 II III I I II III 2% 5

7 20%70% % 20.6% 14.5% / / % % 100%

8 % 69.5% % % 80%

9 % 25% 30% % 21% 19.25% 3.5% 15.75% % / / Ax + y = x 1 A i a i i x y 1 1 A x y { p 1, p 2,, p n }

10 { l, t, d, r } p + = a1 p1 + a2 p2 + + an pn + l + t + d r 2 w { q t, q d, q r }{ t, d, r }2 p + = a p + a p + + an pn + l w + t qt + d qd rq r { p 1, p 2,, p n }{w, q t, q d, q r } 13 1 a + + a + l + t + d + r 4 = 1 + a2 3 n t d r p = A' p + lw + tq + dq + rq 5 A A { l, t, d, r } 1 p = ( I A') ( lw + tq + dq + rq ) I A p = ( I A') ( lw + tq + dq + rq + gq t t d d r r g ) 6 7 g A 7 q g A 96 l % {w, q t, q d, q r, q g } 68% 0.5% I {w, q t, q d, q r, q g } % 76%

11 y 2.55% 1.9% 11% 1.3% II{w, q t, q d, q r } ω t d r r r 7 3 {w, q t, q d } q r 7.3% 82% I II 6.8% % % 114% I II 9.7% 25.4% 3 4.5~7.2% I II 18.6~37.3% III ω ω ω ω 15 ω ω 2% 3 w p 6~7% 4~5% 24~44% 20~30% ~ Rosen Houser

12 5% 10% A 105% 110% 4 40~110% 30~50% ~40% 16 20% % %~44% 15%~21% 5%~11% Ceglowski Golub

13 Balassa, Bela "The Purchasing Power Parity Doctrine: A Reappraisal." Journal of Political Economy, 72(6): Bergsten, C. Fred Correcting the Chinese Exchange Rate: An Action Plan. Testimony before the Committee on Ways and Means, US House of Representatives, March 24. Bosworth, Barry Valuing the Renminbi. Paper presented to the Tokyo Club Research Meeting, February. Ceglowski, Janet, and Stephen Golub, 2007, Just How Low Are China s Labor Costs? The World Economy, 30(4), April, pp Chan, Anita, A Race to the Bottom : Globalization and China's Labour Standards. China Perspectives 46: Cline, William R., and John Williamson Estimates of the Equilibrium Exchange Rate of the Renminbi: Is There a Consensus and If Not, Why Not? Paper presented at the Conference on China s Exchange Rate Policy, Peterson Institute, Washington DC, October. Coudert, V. and C. Couharde (2005), Real Equilibrium Exchange Rate in China, CEPII Working Paper No , Paris. Frankel, Jeffrey On the Yuan: The Choice between Adustment under a Fixed Exchange Rate and Adustment under a Flexible Rate. CESifo Economic Studies. Goldstein, Morris, and Nicholas Lardy China s Exchange Rate Policy Dilemma. American Economic Review, 96(2), May, pp Krugman, Paul The Chinese Disconnect. New York Times (October 22). Midler, Paul, Poorly Made in China: An Insider's Account of the Tactics Behind China's Production Game. Hoboken, New Jersey: Wiley. Rosen, Daniel H., and Trevor Houser What Drives China s Demand for Energy (and What It Means for the Rest of Us), in C. Fred Bergsten, Nicholas Lardy, Bates Gill, and Derek Mitchell, eds. The China Balance Sheet in 2007 and Beyond, Washington: Peterson Institute and Center for Strategic and International Studies, April. Samuelson, Paul A "Theoretical Notes on Trade Problems," Review of Economics and Statistics, 46(2): Subramanian, Arvind. 2010, New PPP-based estimates of renminbi undervaluation and policy implications, Policy Brief Washington: Peterson Institute. Wang, Tao Exchange Rate Dynamics. In E. Prasad, ed., China s Growth and Integration into the World Economy: Prospects and Challenges, IMF Occasional Paper no.232 (Washington: International Monetary Fund)

14 2004 : : :( ) () : 2010 : SSRN : :

15 1. = Penn World Table p 1 p 2 ω p 3 p 4 p w 14

16 / 1. / / / % 2 / 3 / 35% 1.5 / 2 / 35% 100% / a. 65 b c d e

17 %

18 % % % 2% %

Coudert and Couharde 2005 Goldstein and Lardy % 36% Cline and Williamson 2007 Penn World Table = 100 Krugman 2009 Berg

Coudert and Couharde 2005 Goldstein and Lardy % 36% Cline and Williamson 2007 Penn World Table = 100 Krugman 2009 Berg * / 1 1980 2005 25 2004 1980 37% 2006 1 2002 2004 2005 2007 2009 enhanced-ppp 2005 30% Bosworth 2004 Coudert and Couharde 2005 Frankel 2006 Subramanian * 100871 tangxiang_pku@ 163. com 1 108 2006 2012