Why haven't we seen more inflation in China? According to the standard economic model, any country experiencing very rapid productivity growth in the tradable goods sector will see a rise in the real value of its exchange rate.
This can occur in two ways. Either the nominal exchange rate will rise or, if it doesn't, the resulting current account inflows will cause monetary expansion, which will cause domestic prices to rise.
This is just another name for inflation. A country that runs large and persistent trade surpluses and a pegged exchange rate should gradually see an erosion of those trade surpluses as rising domestic prices increase the external price of that country's exports.
For the past decade, the rapid growth in Chinese productivity has far exceeded that of its trade partners and has also far exceeded the growth in domestic wages. The natural result should have been a gradual but strong appreciation of the yuan.
But the level of the yuan is set by the People's Bank of China, and its total appreciation in the past decade has been much less than the relative growth in productivity. As a result, China has seen a surge in its trade surplus. As a share of global gross domestic product, China's trade surplus is easily the highest recorded in the past 100 years.
This is all the more striking when you consider that the two previous record holders, the United States in the late 1920s and Japan in the late 1980s, were relatively much larger economies. The US represented more than 30 per cent of global GDP in the late 1920s, and Japan represented 15 per cent in the late 1980s. By contrast, China represents only 8 per cent of global GDP today.
