This is likely to continue for the next two decades as China continues to implement market-oriented reforms alongside rapid industrialisation and urbanisation.

In this context, the price of China’s non-tradable goods – such as wages for unskilled labour and property prices – will likely continue to rise relative to the prices of tradable goods, which are set by global markets. In the next two decades, China’s price levels will gradually but steadily converge towards those in Hong Kong and the United States, through structural inflation or structural renminbi appreciation – or both.

Since the inflation rate and currency appreciation necessarily associated with productivity catch-up can cause distortions, shocks and income redistribution, the critical challenge for Chinese policymakers is to mitigate any potential dislocation created in the adjustment process.

There are two key policies that can be pursued.

First, when structural inflation emerges, it is critical for China to raise nominal interest rates. This will avoid the asset bubbles caused by negative real interest rates, and will protect the value of bank deposits held by low-income households who cannot afford to hedge against structural inflation by investing or speculating in property markets.

By way of example, China’s urban residential real estate prices have grown on average by about 9 per cent a year since 1991, but the mortgage rate is only about 5 per cent and the one-year fixed-deposit rate is only about 2 per cent. Such structural inflation in property and low mortgage and deposit rates implies a very serious problem of negative real interest rates in terms of  property investment. These negative real interest rates are at the root of China’s property bubbles and associated huge income redistribution from depositors (usually poor) to mortgage holders (usually the rich).

If China cannot maintain a positive real interest rate, the boom and bust cycles in its property sector will likely continue, leading to serious inefficiency in investment and social instability. Conversely, if China does raise interest rates to a level higher than its structural inflation, it will need adequate capital control mechanisms to deal with speculative capital inflows.

But this problem is solvable, and brings us to the second policy point; China must permit reasonable structural inflation.

Specifically, China need not rely solely on nominal exchange rate flexibility to facilitate its rising price levels. Instead, it can tolerate higher structural inflation and the associated real appreciation of the renminbi.

In fact, by allowing for reasonable structural inflation, China can much more easily implement a flexible exchange rate regime. With inflation, there will be potential for the currency to depreciate when inflation runs beyond productivity growth.

Further, a mixture of inflation and nominal appreciation would create a regime in which the market exchange rates could go up or down.  This would reduce the incentive for massive speculative holdings of the renminbi. Such speculative holdings have become a key driver of China’s foreign exchange reserve bubble.

Since the peg has a stabilising function, when China pegs its renminbi to the US dollar, it need not worry much about runaway inflation. If the inflation rate goes beyond China’s underlying productivity growth, the market will expect the renminbi to depreciate, which will lead to capital outflows and the tightening of money supply.

There is one final point to be made.

While the debate over the RMB’s exchange rate is often framed in terms of global trade imbalances, the exchange rate is a price not just for trade but for assets. In fact, asset markets are much larger than trade markets. Thus, maintaining stable exchange rates so as to facilitate stable and efficient cross-border capital flows between the US and China is more important than using the exchange rate to correct global trade imbalances. And in any case, using trade policies might be a more productive way of  correcting China’s trade imbalances.

In sum, given China’s huge foreign exchange reserves, it will be easy for China to defend its peg and avoid runaway inflation. And, as soon as China starts to tolerate reasonable structural inflation and the associated appreciation of its real exchange rate, the pressure for nominal exchange rate appreciation on the RMB will be reduced.

Geng Xiao is the Director of Global Centers/East Asia, Columbia University, located in Beijing and a non-resident senior fellow at the Brookings Institution.

This essay is a summary of an article published in Ross Garnaut, Jane Golley and Ligang Song (eds): ‘China, The Next 20 Years of Reform and Development’.