Excess Labor Supply, Structural Change and Real Exchange Rate

Since China joined the World Trade Organisation in 2001, the Chinese economy has grown rapidly, especially the tradable goods sector. However, the Chinese real exchange rate did not exhibit a persistent and stable appreciation until 2005. This is a puzzling fact that is inconsistent with theories. This paper documents several stylized facts during the economic transition and argues that two features of the Chinese economy may help explain the puzzling real exchange rate pattern for the Chinese economy: i) the faster total factor productivity (TFP) growth in the export sector compared with the import sector; and ii) excess supply of unskilled labor. We construct a small open economy model with an H-O trade structure. We show that, due to heterogeneous skilled labor intensity in export and import sectors, faster TFP growth in the export sector over that in the import sector will lead to the decline of return to capital and a rise of the skilled wage. Therefore, the decrease of return to capital and the persistent low unskilled wage, which is caused by the excess supply of unskilled labor, inhibit the rise in the relative price of non-tradable goods to tradable goods and the appreciation of the real exchange rate. Furthermore, we develop a dynamic small open economy model with multiple tradable goods sectors. We show that the model does fairly well in explaining the Chinese real exchange rate and other stylized facts in the economic transition. Finally, we demonstrate that our hypotheses are supported by cross-country evidence.