What drives long-term real exchange rate movements, and what is the Balassa-Samuelson effect?

Real exchange rates can deviate from PPP for extended periods due to structural economic differences. The Balassa-Samuelson effect is the most important explanation.

Real Exchange Rate Defined:

The real exchange rate adjusts the nominal rate for price level differences:

q(d/f) = S(d/f) x (P_foreign / P_domestic)

If q = 1, PPP holds perfectly. Deviations from 1 indicate currency misalignment in purchasing power terms.

The Balassa-Samuelson Effect:

This explains why currencies of faster-growing economies tend to appreciate in real terms. The mechanism:

1. Productivity growth in tradeable goods (manufacturing, tech) tends to be faster in rapidly developing countries
2. Wages in the tradeable sector rise with productivity
3. Wages in the non-tradeable sector (services, government) also rise because workers can switch sectors
4. But productivity in services hasn't increased, so higher wages mean higher service prices
5. The overall price level rises faster than in slower-growing countries
6. If the nominal exchange rate doesn't fully depreciate, the real exchange rate appreciates

Example:

Consider Meridia, a fast-growing emerging market:

• Manufacturing productivity grows 6% per year (vs. 2% in the US)
• Service sector productivity grows 1% per year in both countries
• Wages in Meridia rise 5% across all sectors (pulled up by manufacturing)
• Service prices in Meridia rise ~4% per year (wage growth minus low productivity growth)
• US service prices rise ~1% per year
• Meridia's CPI rises 3% more than US CPI
• The Meridian peso appreciates ~3% per year in real terms

Other Drivers of Real Exchange Rate Trends:

Investment Implications:

At Pinnacle Global Asset Management, an analyst forecasting the Chinese yuan must distinguish between:

• Nominal depreciation (if China has higher inflation than the US) implied by PPP
• Real appreciation driven by Balassa-Samuelson (productivity convergence)

The net nominal exchange rate movement depends on which force dominates.

Exam tip: CFA Level II often asks whether a country's real exchange rate is expected to appreciate or depreciate. Look for clues about relative productivity growth rates, terms of trade changes, and fiscal policy. The Balassa-Samuelson effect means fast-growing EM currencies should appreciate in real terms even if PPP suggests depreciation.

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