What is the Balassa-Samuelson effect and how does it affect exchange rates?

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AcadiFi · Accepted Answer

The Balassa-Samuelson effect explains why richer, more productive countries have higher price levels. The mechanism: productivity growth is faster in tradable-goods sectors (manufacturing) than non-tradables (services). In a country with rapid tradable productivity growth, wages rise in tradables; labor-market arbitrage pushes up wages in non-tradables without matching productivity gain; non-tradables prices rise; overall price level rises; the real exchange rate appreciates.

Historical example: Japan 1960-90 saw manufacturing productivity triple relative to the US. Real JPY/USD appreciated from 360 (1971) to 80 (1995), much of it structural Balassa-Samuelson. China 2000-2015 showed similar dynamics: rapid tradables productivity with RMB real appreciation about 35%.

Implications for portfolio managers: emerging markets with rapid productivity convergence should see real currency appreciation as a structural tailwind to dollar-denominated returns. Emporia Emerging Macro overlays Balassa-Samuelson forecasts on current-account analysis to identify currencies with structural appreciation potential.

The effect is muted when capital controls limit financial integration, or when productivity growth is broad-based across sectors (unusual). It also implies that simple PPP comparisons across income levels understate price-level differences; the 'Big Mac index' systematically shows EM currencies as undervalued partly because of Balassa-Samuelson.

What is the Balassa-Samuelson effect and how does it affect exchange rates?

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