Renminbi Appreciation and China's Industrial Upgrading

• Published date: 01 May 2022
• Author: Chin‐Yoong Wong,Yoke‐Kee Eng
• Date: 01 May 2022
• DOI: http://doi.org/10.1111/cwe.12416

©2022 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 1–22, Vol. 30, No. 3, 2022 1

*Chin-Yoong Wong, Professor, Department of Economics, Faculty of Business & Finance, Universiti

Tunku Abdul Rahman, Malaysia. Email: wongcy@utar.edu.my; Yoke-Kee Eng (corresponding author),

Professor, Faculty of Business & Finance, Universiti Tunku Abdul Rahman, Malaysia. Email: engyk@utar.

edu.my.

Renminbi Appreciation and

China’s Industrial Upgrading

Chin-Yoong Wong, Yoke-Kee Eng*

Abstract

To identify the macroeconomic environment that has enabled China’s industrial upgrading

during a period of persistent renminbi appreciation, we construct a two-country New

Keynesian model of industrial upgrading with a global production network, endogenous

fi rm entry, and a directed quality frontier. We show that renminbi appreciation promotes

industrial upgrading without hurting real economic growth in the longer run. This holds

true especially through four channels. First, the quality threshold for fi rm entry is lower

to allow for more fi rms participation and thus greater product varieties (quality threshold

channel). Second, upstream skill-based production uses more imported inputs of higher

quality (imported input channel). Third, there is substantial global demand towards the

exports of high-quality inputs (global demand channel). Fourth, domestic inputs are

competing against imported inputs to broaden the scope for competition in the upstream

product market to incentivize quality upgrading (scope for competition channel).

Keywords: endogenous firm entry, global production sharing, industrial upgrading,

renminbi appreciation, structural reform

JEL codes: F41, F43, O11, O43

I. Introduction

The Chinese renminbi (RMB) had been appreciating steadily by nearly 1 percent per

quarter on average after the abolition of the offi cial US dollar (USD) peg in July 2005.

The trend was reversed only when the Chinese economy started to lose steam in early

2014. It is surprising that 8 years of appreciation did not take a toll on China’s growth

potential. Throughout this period, industrial production and per capita real gross

domestic product grew as rapidly as they had during the period of the USD peg in the

aftermath of World Trade Organization accession.

Chin-Yoong Wong, Yoke-Kee Eng / 1–22, Vol. 30, No. 3, 2022

©2022 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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This development, however, is not aligned with conventional wisdom, which

argues that real depreciation promotes economic growth through resource allocation,

technology transfers, and learning-by-doing externalities (Eichengreen, 2008). The

much-debated Rodrik (2008), for instance, show evidence on the correlation between

undervaluation and economic growth in developing countries (Nouira et al., 2011).

Alvarez and Lopez (2009) argued that fi rms facing real exchange rate depreciation enjoy

an increase in export profi tability, accelerating the use of skill-intensive techniques and

improvement in product quality.

This, however, may not be the case for countries like China, which are integrated

deeply into global production networks. Yan et al. (2016), for instance, showed that

the growth effect of real effective exchange rate depreciation in coastal areas was

nullifi ed by corresponding increases in the cost of imported materials and intermediate

inputs for the 2000–2011 period. Lardy (2019) argued that appreciation in the RMB

has largely eliminated the implicit tax on service sectors due to RMB undervaluation,

facilitating a growth rebalancing towards domestic consumption and the service

sector.

Empirical evidence on how nominal RMB appreciation contributes to China’s eff ort

to upgrade industrial structure has started to accumulate. Hu et al. (2021) argued that

appreciation promotes an improvement in the quality of exports by inducing a switch

to higher quality intermediates. Using highly disaggregated Chinese data through a

heterogeneous-firm trade model lens, Li et al. (2014) found that RMB appreciation

significantly encouraged firm entry that added to the new product varieties. Zhang

and Ouyang (2018) found that an improvement in export structure facilitated by RMB

appreciation occurred in the new products. Hsu et al. (2014) also showed that China’s

export structure became more like that of the developed countries after the currency

appreciation, as stiff competition reallocated resources away from the low mark-up

sector toward the high mark-up sector.

But can causation go the other way round? After all, persistent movements in real

exchange rates have been attributed to cross-country diff erentials in labor productivity.

This is known as the Balassa−Samuelson effect. Figure 1 displays an interesting co-

movement between the nominal USD−RMB exchange rate, China’s real effective

exchange rates (REER), and labor productivity relative to that of the US during the

periods of 2004 to 2019.

Two observations stand out that defy this conjecture. First, as the RMB appreciated

steadily after being de-pegged from the USD in 2005, real appreciation followed closely.

This was arguably more of an outcome of the currency regime change than of high