Brad Setser's post today regarding "Why is China’s government trying so hard to hold down China’s current living standard?" is an excellent discussion of the issues facing China's leaders today. Here is a response that I posted at his blog:
This description of China today sounds an awful lot like descriptions of Japan in 1989 when Japan's economic boom was at its peak. If one substitutes "Japan" for "China" in your statement "China’s government has had a policy of, in effect, subsidizing the use of Chinese labor for the production of goods for export" you would have a fair description of Japanese domestic labor policy. At that time, Japan's export sector was being subsidized at the expense of Japanese consumers, who in spite of the massive increase in GDP that had taken place since the 1970's who had a lower average standard of living than US consumers. As an example, one could purchase Japanese-made cameras more cheaply in the US than in the markets at Akihabara in Tokyo. Japanese people lived in tiny apartments or homes (and still do) compared to their US counterparts. Japanese companies paid huge amounts for US assets, particularly real estate, that turned out to have been gross overpayments (think of the Pebble Beach golf course).
I think that the core issue for the PBoC is that if the RMB is allowed to go to its market price, then China's export sector will suffer severely. Given that the export sector has been the primary source of per capita income improvement, the PBoC is reluctant to kill this golden goose, even though it knows that RMB appreciation is needed in the long run.
Also, if China allows wages to increase, that would funnel through to increased prices for Chinese goods on the world market leading to some amount of negative export growth. The key is to balance the increase in domestic consumption that would result from higher wages with the decrease in exports. I don't think that it is humanly possible to manage that balance without dislocations. When the dislocations come, Chinese leaders can point fingers at the US all day long, but the talk won't mean anything. Especially when Chinese policy has been to systematically torpedo US investment in tradables production capacity.
To get back to my analogy with Japan, I would say that China can now look forward to a similar long period of stagnation in sectors that have been experiencing bubble-like growth and difficulty in getting GDP growth from the domestic sector.