It is the inflation-adjusted [real] exchange rate, together with the pace of real GDP growth, that dictates how quickly dollar incomes in developing countries catch up with those of rich economies. If China does indeed have little surplus labor left to move off the land, the real exchange rate could rise rapidly as wages sprint ahead, pushing up unit labor costs in services, where the productivity of jobs such as hairdressers and waiters is lower than in manufacturing.China overtaking the US in [nominal] exchange rate terms will obviously be hastened by a stronger yuan. In turn, the pace at which revaluation will occur is closely related to labour availability going forward as wage pressures help determine this rate. I found the discussion quite interesting and dug out Kuijs' article. Here's what he says in full:
Louis Kuijs, a World Bank economist in Beijing, has doubts whether China's labor market has reached a turning point. This makes it tough to forecast the currency. So Kuijs, in a recent paper, maps two paths. One assumes a rise in the yuan's real, trade-weighted exchange rate of 0.8 percent a year; the other assumes a 3 percent rise, in line with the experience of Japan from 1965-1990 and South Korea from 1970-1996.
What's striking is how little difference this makes. Under the slow appreciation scenario, China overtakes the United States as the world's biggest economy in 2029; if the exchange rate rises faster, it does so by 2023.
However, with substantial wage growth for migrants in recent years, discussions on the possible exhaustion of surplus labor and the “Lewis turning point” [see here] have intensified in China, particularly after some high profile labor disputes and wage increases in May-June 2010. Several observers have concluded that China may soon exhaust its surplus labor. If true, substantial sustained [Balassa-Samuelson] effects in the coming decade may drive up the real exchange rate.And here are figures 16 and 17 if you're curious depicting accelerating rates of nominal growth under 0.8% and 3.0% annual revaluation scenarios, respectively [click for a larger image]:
It is not clear how much RER appreciation there will be in the coming decade. Looking at the labor market data, it seems unlikely that China has already exhausted its surplus labor. The official employment statistics suggest that over 40 percent of China’s employees are still employed in agriculture, where labor productivity is 1/6th of that in the rest of the economy. Even after adjustment for possible overstatement of agricultural employment following Brandt, Hsieh, and Zhu (2008) by as much as 10 percentage point, agricultural employment is relatively high. This would suggest that surplus labor is still sizeable, especially considering expected future technological change in agriculture and additional surplus labor in the cities. [T]his would suggest that sustained RER appreciation would still be quite some time away in the future. However, it is possible that China’s upcoming demographic changes, which are going to affect the economy at a relatively early stage of development, will advance substantial trend RER appreciation in China compared to the typical pattern.
Given the uncertainty over the pace of the RER in the coming decade, we present 2 long term paths. In the lower path, we assume average RER appreciation of 0.8 percent per year against the US dollar. This is broadly the average of those countries with RER appreciation against the dollar during this period. In this path, and using the Consensus Forecast growth projections for the US mentioned above, China's GDP per capita in current prices and exchange rates would increase from 8.2 percent of the US level in 2009 to 16 percent in 2020 (Figure 16). China’s total GDP was 35.8 percent of that of the US in 2009. This ratio would increase to 66 percent in 2020. Extending the growth accounting, along this path China would overtake the US as the largest economy in 2029.
Along the upper bound path, the real exchange rate appreciation is assumed to be 3 percent per year. This is broadly in line with what it was in Japan during 1965-1990 and South Korea during 1970-1996. It seems a high rate compared to the experience of most other countries. But, there may be some pent up room for real appreciation in China, after the resistance to it in the previous decade, including from possible adjustment of prices of resources. Along this path, using the same assumptions on real growth, China's GDP per capita in current prices and market exchange rates would increase to 20 percent of the US level in 2020 (Figure 17). China’s total GDP would increase to 82 percent of that of the US in 2020. Along this path China would overtake the US as the largest economy in 2023.
The difference between the 2 scenarios is not so large through 2020, because real GDP catch up is relatively large then. Extending the scenario further out, the differences become larger, as the role of real catch up becomes smaller compared to that of RER appreciation.
Does it sound like a date with destiny, then? I remember the hoopla surrounding Japan overtaking the US in the Eighties, but I think China's far larger population and far lower per capita income indicate the PRC still has some ways to go.