Legend has it that, after tasting succulent noodles during his travels, one of the discoveries that Marco Polo brought back from China became Italian pasta. We think Italy can finally repay this long-overdue debt by exporting its postwar currency policy to China.
Like many emerging markets, China is engaged in a convergence process. Its GDP-per-capita is catching up with levels in developed economies. Given where it started and its vast population, this process will still take many years. But it seems that China, like South Korea, Singapore or Malaysia before it, is inexorably advancing on the convergence path.
When a country grows richer and slowly closes the wealth gap with more developed economies, there are several inevitable consequences. One is that the prices it asks for its exports increase over time. Or, in more technical language, its domestic currency appreciates in real terms.
Real exchange rates not only express the nominal exchange rate – that is, how many units of one currency you get for another. They also determine the relationship between domestic and foreign prices, for example, how many Chinese noodles you can buy in the US for the price of a kilo of noodles in China. As China converges towards the US, then a real appreciation of its currency would mean you get more noodles in the US for the price you pay in China. China would be catching up with the Americans and hence becoming relatively richer.
The convergence that we are seeing today in China and other emerging markets took place in Europe following World War II. Both Germany and Italy exited the war with very low GDP-per-capita levels relative to the US. As they developed in the decades following the war, they caught up with America and saw a real appreciation of their currencies. However, this real appreciation took two different forms.
Germany’s pre-war history gave it a severe case of inflation phobia. The real appreciation of the German mark occurred through nominal exchange rate appreciation, while Germany’s inflation was kept very low. If you get more dollars for one German mark, then you will get more German sausages in the US for the price of a kilo of sausages in Germany, even though the price in Germany remains constant.
In Italy, the real appreciation took another route. The nominal exchange rate was kept constant (the lira actually even depreciated against the US dollar), but Italy experienced a very high inflation rate. If the price of pasta increases in Italy (inflation), then you will obviously get more pasta in the US when you spend an amount equal to the price of a kilo pasta in Italy, even though the exchange rate between the US dollar and the Italian lira remains constant.
Confronted with the real appreciation of their currencies, today’s converging economies have a choice. To state the extremes, they can either let their currencies appreciate nominally and keep inflation low, the German way, or they can follow the Italian way and keep their exchange rates under control, with the risk of surging inflation. Economics is ultimately a science of choices and trade-offs.
Calling for the yuan to appreciate, the US wants China to pursue the German way. The Chinese disagree. They argue that an abrupt appreciation would harm their economy. Opting for the more subtle, Italian way – more inflation in exchange for a constant exchange rate – China thinks it can boost domestic demand with less disruption than the German route offers. And more domestic demand in China will also mean more exports to China, even for the US.
An ancient Chinese proverb states: “With time and patience, the mulberry leaf becomes satin.” With time and patience, the yuan’s real appreciation through inflation will benefit US exporters much more than a quick-fix nominal exchange rate surge.
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