1. INTRODUCTION

In the present work, we attempt to explain the long-run behavior of two currencies, the Chinese Renminbi (RMB) and the US dollar (USD) for the period 1982-2018 based on the classical economic premises of actual competition, labor theory of value and absolute cost advantage. We limit the analysis to these two economies because of their significant weight in international trade and of the observed intense political controversy over the effectiveness of currency manipulation policies, especially from China’s side which, in the recent decades, has emerged as a major player in international trade reporting mounting surpluses.

The real exchange rates (RERs) affect the competitiveness of an economy and studying its determinants and evolution over time can give us policy insights into how an effective trade policy can be implemented. This is the reason why the long-run determinants of RERs have probably been researched more than any other topic in international finance and trade. The conventional models fail to depict the determinants of RERs and display low predictive capacity arising mainly from their reliance on the principles of comparative cost advantage and purchasing power parity (PPP). Thus, an alternative proposal for the determination of RERs is in demand which could help to design effective and sound policy proposals. The present paper aims to contribute to this area by developing a model that is based on key propositions of the classical political economy according to which real competition rules domestic and international trade, the labor theory of value defines domestic and international prices and the principle of absolute cost advantage shapes international trade.

The remainder of the paper is organized as follows: Section 2 briefly reviews the pertinent literature on the determinants of RERs by pointing out its theoretical and empirical shortcomings. Section 3 presents a model which, based on the principles of classical political economy, is designed to outline the determinants of RERs. Section 4 discusses and critically evaluates the econometric results derived from the application of the Auto Regressive Distributed Lag (ARDL) method on the proposed model. Finally, Section 5 summarizes and makes some concluding remarks.

2. CONVENTIONAL PROPOSALS FOR THE DETERMINANTS OF EXCHANGE RATES

The traditional proposals about the determinants of RERs rely on two basic principles: The PPP and the comparative cost advantage. Based on these two basically similar in principle theoretical approaches, it is argued that ‘free’ trade brings about a trade balance between two economies while their growth rates converge over time. This is the reason why ‘free’ trade policies are suggested and implemented so that economies can enjoy the ‘mutual’ benefits from their international transactions.

According to PPP principle, the price levels of the two economies display changes such that converge is attained while ‘free’ trade ensures the same prices for the same goods². That is, the nominal exchange rate, e_i/j, adjusts so that a balance is achieved between the price levels, p_i and p_j, while the RER, ei/jr, of economy i for the same basket of goods in common currency with economy j is defined as:

In standard international trade theory, the ‘law of one price’ is not employed as a mechanism determining the RERs, but as a rule defining the effectiveness and the level of competition; instead, prices converge internationally because of the principle of comparative advantage, which imposes the trade balance between the partner-economies. In fact, the PPP premise is ‘tacitly’ based on the principle of comparative advantage, as it basically proposes that the nominal and, consequently, the RERs converge in the long-run and remain stationary; so that the economies involved attain, at the end, a trade balance and become competitive in the commodities they specialize.

Many studies have questioned, theoretically and empirically, the attainment of stationary RERs and conventional economics admit that the PPP hypothesis does not hold in the real world (^{Taylor and Taylor, 2004}; ^{Harvey, 2009}). In addition, using a variety of macroeconomic fundamentals (i.e., money supply, government expenditures, capital flows, trade openness, interest rate differentials, terms of trade, productivity, etc.) as determinants of RERs, numerous studies reached results that are contradictory and depended on the level of development and size of the economy, the period under consideration, the exchange rate regime and the particular model employed (^{Égert, Halpern, and MacDonald, 2006}; ^{Choudhri and Schembri, 2010}; ^{Corsetti, Meier, and Müller, 2012}; ^{Hnatkovska, Amartya, and Vegh, 2016}; ^{Miyamoto, Nguyen, and Sheremirov, 2019}; ^{Cuestas, Monfort, and Shimbov, 2022}). As a result, these efforts are doomed to be limited to case studies not capable to provide credible answers to relevant questions and to design effective trade policies.

One outcome that has been repeatedly confirmed and questions the validity of the premises of the traditional trade theory is that some countries constantly show trade-surpluses (Japan) and others trade-deficits (USA) (^{Shaikh and Antonopoulos, 2013}). The same is observed for various European Union countries (^{Seretis and Tsaliki, 2015}; ^{Tsaliki, Paraskevopoulou, and Tsoulfidis, 2018}; ^{Poulakis, Poulakis, and Chatzarakis, 2022}), for Mexico and USA (^{Martínez Hernández, 2010}, ²⁰¹⁷) and for China and USA (^{Tsoulfidis and Tsaliki, 2019}). ^{Ricci (2019)} studying the trade between 16 world regions identified (as expected) two types of economies: Those with trade-surplus and those with trade-deficit. Naturally, the economies with trade-surplus are those that become international lenders by exporting their surplus as debt to economies with trade deficit.

Hence, the hypothesis that permeates ‘free’ trade modeling according to which equal value of goods is exchanged between trading partners (^{Shaikh, 2016}; ^{Tsaliki, Paraskevopoulou, and Tsoulfidis, 2018}; ^{Tsoulfidis and Tsaliki, 2019}) is dubious. In effect, we come across with countries-economies that experience persistent trade surpluses and other deficits indicating that trade (domestic or international) is the mechanism through which transfers of value from the less to more technologically developed capitals, which are primarily concentrated in the developed economies, take place (^{Seretis and Tsaliki, 2015}; ^{Tsaliki, Paraskevopoulou, and Tsoulfidis, 2018})³. In other words, as ^{Shaikh and Antonopoulos (2013)} pointed out, all capitals and, by extension, economies do not equally gain from international trade, but only those with an absolute cost advantage over the others; as a result, trade imbalances between economies are persistent and gradually expand over the years. In addition, currency manipulation can neither determine nor explain the surpluses in an economy’s current account (^{Weber and Shaikh, 2021}).

A noteworthy issue arising within the traditional theory of international trade is that the various models treat national economies as trading partners; however, trade takes place exclusively between capitals (businesses) whose survival in the international arena depends on the productive conditions which in turn define prices in the domestic market and the RERs in the international arena. Hence, the search for the determining factors of RERs should focus on how these capitals organize and compete in the international markets and to what extent, if any, the outcomes of competition in the international arena differ from those in the domestic markets.

3. DETERMINING FACTORS OF THE RERs

The PPP and the comparative cost advantage principles form the theoretical and empirical framework of international trade theory, regardless of the conflicting evidence and the poor predictive performance of the employed models on the determining factors of RERs (^{Isard, 1995}; ^{Antonopoulos, 1999}; ^{Martínez Hernández, 2017}; ^{Shaikh, 2016}). Therefore, it becomes imperative to establish an alternative approach to determine the RERs which will be theoretically and empirically sound so that the subsequent economic policy proposals will be realistic and effective. In pursuing this, we construct a model based on the ideas governing the classical political economics; namely, the labor theory of value, the actual competition and the principle of absolute cost advantage.

According to the classical theory of competition, the free flows of capital between sectors and economies form two separate and dialectically unified moments: The intra-industry and inter-industry competition which impose two specific laws on the national and international transactions. The intra-industry competition imposes the ‘law of one price’ which gives rise to differential profitability in the capitals operating in the same industry and causes the transfer of value from the less to the most advanced producers. Inter-industry competition brings to the fore the ‘law of the tendential equalization of profit rates’ that defines the equilibrium price (price of production or long-run equilibrium price) of the commodity which encompasses the regulating conditions of production in the industry that is activated and incorporates the socially necessary working time required for the production of the specific commodities (^{Carchedi, 1991}; ^{Tsaliki and Tsoulfidis, 2015}).

The equalization of the profit rates across industries, however, is not carried out for all capitals but only for those that produce with the best generally available production method, that is, for the regulating capital; the price that prevails in the industry (“law of one price”) incorporates this average rate of profit. Essentially, the regulating capital is the type of capital that dialectically connects the two distinct moments of competition, the intra-industry and inter-industry competition. As a result, capitals within an industry enjoy different profitability despite the “law of the equalizing tendency of the rate of profit” (^{Guerrero, 1995}; ^{Tsoulfidis and Tsaliki, 2005}). The consequence of the operation of both laws is the transfer of value from the less to more advanced capitals (^{Seretis and Tsaliki, 2015}; ^{Tsaliki, Paraskevopoulou, and Tsoulfidis, 2018}). Consequently, domestic or international trade favors the capitals that produce with more advanced methods of production than the corresponding regulating capitals; in other words, the capitals (firms) that operate with the lowest production costs win. Thus, advanced and better equipped capitals receive value transfers produced by other capitals; even from capitals from other countries. The final outcome is the dominance of the absolute cost advantage hypothesis, which becomes the governing principle for both domestic and international trade (^{Shaikh, 1991}). According to this principle, the most advanced capitals through domestic and international trade prevail over the rest regardless of their location.

If the classical competition is the mechanism that shapes the rules governing domestic and international transactions, the labor theory of value is underneath the operation of real competition by determining the domestic and international prices and through them the establishment of the absolute cost advantage principle. Since the RERs express the value of a country’s good into another currency, the adopted theory of value has to be in the core of their analysis. According to the labor theory of value, the relative prices of commodities are directly proportional to the relative labor times spent on their production or, as eloquently put it, to their relative vertically integrated unit labor costs (^{Shaikh, 1991}; ^{Guerrero, 1995}; ^{Tsoulfidis and Tsaliki, 2019})⁴ reflecting labor productivity and the level of mechanization of the production process. In particular, if p is the production price of a commodity and v is its vertically integrated unit labor cost, then for two capitals, 1 and 2, operating within an economy we have:

This long-run proportional relationship between relative prices and vertically integrated unit labor cost of commodities applies not only in domestic but also in international transactions (^{Guerrero, 1995}; ^{Martínez Hernández, 2017}; ^{Tsaliki, Paraskevopoulou, and Tsoulfidis, 2018}; ^{Boundi-Chraki and Perrotini-Hernández, 2021}). In the case of two capitals, where i stands for domestic and j for the foreign country, the RER, ei/jr, for the same basket of goods expressed into a common currency is defined by:

According to the ‘law of one price’, the price of internationally tradable goods should be the same; hence, if P_iT and P_jT are the domestic and foreign price levels for the internationally tradable goods, respectively, the nominal exchange rate is defined as:

If P_i and P_j denote the domestic and foreign general price levels, respectively, then the RER can be defined as:

Where vir and vir are the domestic and foreign real vertically integrated unit labor costs, respectively, and Ti/j=Pi/Pi,T/Pj/Pj,T. Hence, the RER captures the changes that occur in the labor unit costs and in the price levels (general and internationally tradable) between the trading partners reflecting the ‘law of one price’ in the international arena.

In the empirical analysis that follows, we attempt to identify the determinants of the long- and short-run behavior of RERs incorporating, besides the relative real vertically integrated unit labor cost, two more variables; the real net capital flows (RCF) which is consistently used in similar studies, and the T_i/j capturing the multiple effects exerted by the price level in internationally tradable and non-tradable goods in two economies. The model subjected to empirical testing is of the form:

Specifically, the RER between two economies is expected to be affected:

In the general context of this alternative approach, ^{Shaikh and Antonopoulos (2013)} investigated the RER between the USA and Japan for the years 1962-2008 while ^{Martínez Hernández (2010)} examined the RER between Mexico and the USA for the period 1970-2003; they found that the relative real unit labor cost of tradable goods is the key determinant for the RERs. In a study of 16 Organisation for Economic Co-operation and Development (OECD) countries, ^{Martínez Hernández (2017)} concluded that a relative reduction in the real unit labor costs improves the terms of trade for 15 of the 16 countries of his analysis and, therefore, it becomes the key regulator of the long-run RERs. ^{Antonopoulos (1999)}, examining the trade weighted RERs between Greece and 12 OECD countries for the years 1964-1998 concluded that they depend on the relative unit labor costs. ^{Boundi-Chraki (2021)}, in his work for the North American Free Trade Agreement (NAFTA) countries during the period 1995-2014, found that the vertically integrated real unit labor costs determine the RER while ^{Boundi-Chraki and Perotini-Hernández (2021)} reached the same conclusion in their study for the NAFTA and the European Union countries. Similar were the results in the studies by ^{Casey (1996)} for Canada, ^{Ruiz Nápoles (1996)} for Mexico, and ^{Roman (1997)} for Spain.

4. EMPIRICAL INVESTIGATION OF THE DETERMINANTS OF RER

In this section, we investigate empirically the long-run behavior of the Chinese RMB and the USD for the period 1982-2018. The selection of the specific economies was made because of their mounting weight in international trade and of the recent political controversy over the effectiveness of currency manipulation policies. Hence, a rigorous analysis of the determinant factors of RER between these two economies can offer an understanding of their current trade position but also may help design effective trade policy which, after all, is the objective of the intense debate at a theoretical, empirical and, mainly, political level. The model employed in our analysis is⁵:

Wherei RERi/j,T=ei/jr the RER of country i weighted by its trade volume of tradable goods with 17 trade partners, j. RULCi/j,T=viTr/vjTr is the ratio of real unit labor cost for tradable goods of country i weighted by their trade volume real unit labor costs of the 17 trade partners, j. The lack of input-output data for such a long period restricts us to use real unit labor costs instead of the vertically integrated real unit labor costs. In addition, the analysis refers only to manufacturing industries since they mostly produce internationally tradable goods⁶. RCF_i is the real net capital flows of country i. T_i/j = τ_i/τ_j is the index capturing the various effects that price differentials may exert on RER determining factors and are not captured by the stochastic term. c and e are the constant and the residual, respectively. The i refers to domestic economy and j represents the foreign consisted of the weighted average of 17 countries.

Figure 1 presents the evolution of the RER_i/j,T (solid line) and RULC_i/j,T (dashed line) for China and USA. The period of analysis is 1982-2018 which is long enough to capture the changes occurring during the different phases of the last economic cycle.

Figure 1 The trade-weighted RER and real unit labor cost of tradable goods, China and USA, 1982-2018 (2010 = 100) 

In Figure 1, we observe that the two variables under consideration follow a common pattern over time in both countries. For the US (right-hand side panel), the rising value of the dollar stopped after the Plaza Agreement (1985) which imposed its devaluation against the currencies of Japan, West Germany and the United Kingdom. The ensuing Louvre Agreement (1987) prioritized international exchange rate stability and the stabilization of the USD, which continued to decline in international foreign exchange markets following closely the decline in the unit labor cost. As for China (left-hand side panel), in the first years of the analysis, the RMB followed a declining trend which has been reversed since 1994 following closely the real unit labor cost. Hence, we may argue that over the years, China’s relative real unit labor cost has increased indicating that the trade-weighted unit labor costs of its partners decrease faster. Hence, we observe that the Chinese RER appreciates over the years despite the currency manipulation that the Chinese authorities are considered responsible and accused.

In Figure 2, we present the trade balance (solid line) and net real capital flows (dashed line) of China and the US for the period 1982-2018.

Figure 2 Trade balance and capital flows, China and USA, 1982-2018 (2010 = 100) 

In Figure 2, we observe that the US economy experiences persistent trade deficits while China displays persistent trade surpluses; it is worth noting that the same pattern exists in their bilateral trade. We also see that the real net capital flows follow an erratic behavior; in fact, for China we observe that till 2014 there are inflows and for the following years outflows while the US for the whole period experiences only outflows. Hence, the real net capital flows do not ‘correct’ trade imbalances and are expected to display short-run effects on RERs as well.

We continue the analysis by testing the proposed model (Equation [6]) in order to identify the presence of cointegration and long-run effects between the examined variables. We employ the ARDL method⁷. We also perform the Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) tests to ascertain that our variables are not I(2) (see Tables B1-B4, Appendix B). The results reveal that the trade-weighted RER for the USA is not stagnant at first levels questioning, thus, the claim made by the PPP principle; the corresponding variable for China is I(0). Since we deal with a mixture of I(0) and I(1) time series, the ARDL is the most appropriate method to investigate cointegration and long-run relationship between the variables; the structure of time lags in the model is selected based on the Akaike Information Criterion. Table 1 presents the Bounds Tests.

The results in Table 1 confirm the presence of cointegration; thus, we proceed with the estimation of the long-run multipliers, which are presented in Table 2.

From the results presented in Table 2, we can point out the following:

Tables Β5 and Β6 in Appendix B present the error correction models for China and USA, respectively while Table B7 presents the diagnostic tests for the ARDL models used confirming that our results are robust.

5. CONCLUSIONS

In this paper, we explored the dynamics of the RERs based on the premises of the classical political economy; that is, the principle of absolute cost advantage, the labor theory of value and the theory of real competition. The synthesis of them constitutes the theoretical framework upon which our empirical research was conducted. We argue that a model based on the premises of the classical political economy is a reliable alternative proposal for the determination of the RERs according to which the classical competition governs domestic and international transactions, and the labor theory of value is behind the principle of the absolute cost advantage that dominates in both domestic and international trade.

To empirically test the validity of these hypotheses, we examined the long-run behavior of two currencies, the Chinese RMB and the USD. Intentionally, we dealt with these two economies which are immense international trade players and there is an ongoing theoretical and political debate as to what extent currency manipulation affects their respective trade performance. By using the ARDL method, we investigated the extent to which the real unit labor cost defines the RER in China and the USA during the period 1982-2018. The empirical results confirm that for both economies, the real unit labor costs exert a long-run positive and statistically significant effect on their RER; the other explanatory variables employed in the model exert also significant effects, as expected from the theory.

The above results confirm the premises of the classical political economy tradition that international trade is guided by the principle of absolute cost advantage according to which labor (and its approximation by the real unit labor cost) shapes the domestic and international transactions. Our analysis has shown that in both economies under investigation, the RERs are defined mainly by their real unit labor costs in the long run. This outcome indirectly provides support to the well established thesis within the classical political economy tradition that trade is not, by definition, mutually beneficial for all economies as transfers of value take place from the less to more advanced capitals. In addition, the RERs do not automatically change in order to balance international trade as the mainstream trade theories suggest.

In addition, we may point out that useful proposals may be drawn for the exercise of effective economic policies. Specifically, effective exchange rate policies should aim to a course of actions and implementation of strategies that will lower the real unit labor cost. The latter can be attained in two ways; either by decreasing real wages with limited effect in the long-run, or by implementing policies that increase labor productivity. In fact, the continuous improvement in labor productivity emerges as the most effective tool for establishing a sustainable exchange rate policy in the long run.