Understanding the difference in real versus nominal exchange rate changes is a key concept in currency economics. It should be the case that real exchange rate appreciation will change the competitiveness of goods and will affect the balance of payments. An increase in the real rate should lead to a decline in the trade surplus. Nevertheless, empirical research by Chinn and Wei has found that there is little link between flexible exchange rates and changes in the current account.
For all of the talk about fixed or controlled rates in China, there has been a clear appreciation in real terms. The Economist provides a nice graphic which shows that on a real basis, the Yuan has seen significant gains. The problem is that has not resulted in declines in the current account.
In real terms, the US and rest of the world may actually like for China to have higher inflation. If higher inflation leads to higher nominal wages, some of the costs will be past in export prices. This will make Chinese goods more expensive which will change the terms of trade. The effect will be the same as an increase in the exchange rate. Notably this effect will also export inflation to the rest of the world.
There are no easy answers with the China imbalance but we are heading in the right direction.
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