The Real Value of the Yuan and Inflation
A recent NYT article highlighted the fact that international competitiveness (as defined by macroeconomists) depends on not just the nominal exchange rate, but also relative price levels. From Inflation in China May Limit U.S. Trade Deficit by Keith Bradsher:
Inflation is starting to slow China's mighty export machine, as buyers from Western multinational companies balk at higher prices and have cut back their planned spring shipments across the Pacific.
It's useful to recall that one definition of the real value of a currency (defined as number of foreign units of real goods required to obtain one single unit of domestic goods, so up is appreciation) is:
r ≡ e + p - p*
where e is the log value of the currency (number of foreign currency units to obtain one single unit of home currency), p and p* are the log domestic and foreign price levels.
As Chinese inflation (4.6% y/y in December ) exceeds US (or rest-of-world) inflation, then the Chinese real exchange rate appreciates. It's important to keep in mind the magnitude of these effects, though.
Figure 1: Log real value of trade weighed CNY, broad basket. Source: BIS, accessed 2/2/2011.
The BIS (as well as IMF) indices are CPI deflated. As I've discussed elsewhere  , there are actually many definitions of real exchange rates, which depend upon the deflator used. In the article, Bradsher is actually referring to several related versions, including one deflated by manufactured exports prices, and by wages. Clearly, these two are linked -- the higher the wages, the higher the price of the finished good, assuming a constant price-cost margin.
Actually, once one writes out the expression for pricing by a monopolistically competitive firm, one sees the price is a function of the price-cost function (itself a function of demand elasticities) and unit labor costs -- the wage rate divided by productivity. This suggests a more appropriate deflator for assessing competitiveness is the unit labor cost deflated real exchange rate.
Source: IMF Article IV report on China, p.19.
Thus, in focusing on wage movements (which do seem quite dramatic), Bradsher is assuming productivity trends are not too marked relative to wage changes (and further the scope for compression of price-cost margins is limited, which seems reasonable -- although see ). However, unit labor costs have in the past diverged from CPI.
If indeed wages are rising rapidly due to exhaustion of excess labor supply in the coastal regions, then this would be an important milestone in rebalancing the Chinese economy .