An indigestible problem
Oct 14th 2010 | Hong kong link http://www.economist.com/node/17257797?story_id=17257797
A WEAK currency, despite its appeal to exporters and politicians, is no free lunch. But it can provide a cheap one. In China, for example, a McDonald’s Big Mac costs just 14.5 yuan on average in Beijing and Shenzhen, the equivalent of $2.18 at market exchange rates. In America, in contrast, the same burger averages $3.71.
That makes China’s yuan one of the most undervalued currencies in the Big Mac index, our gratifyingly simple guide to currency misalignments, updated this week (see chart). The index is based on the idea of purchasing-power parity, which says that a currency’s price should reflect the amount of goods and services it can buy. Since 14.5 yuan can buy as much burger as $3.71, a yuan should be worth $0.26 on the foreign-exchange market. In fact, it costs just $0.15, suggesting that it is undervalued by about 40%.
The tensions caused by such misalignments prompted Brazil’s finance minister, Guido Mantega, to complain last month that his country was a potential casualty of a “currency war”. Perhaps it was something he ate. In Brazil a Big Mac costs the equivalent of $5.26, implying that the real is now overvalued by 42%. The index also suggests that the euro is overvalued by about 29%. And the Swiss, who avoid most wars, are in the thick of this one. Their franc is the most expensive currency on our list. The Japanese are so far the only rich country to intervene directly in the markets to weaken their currency. But according to burgernomics, the yen is only 5% overvalued, not much of a casus belli.
If a currency war is in the offing, America’s congressmen seem increasingly determined to arm themselves. A bill passed by the House of Representatives last month would treat undervalued currencies as an illegal export subsidy and allow American firms to request countervailing tariffs. The size of those tariffs would reflect the scale of the undervaluation.
How does the bill propose to calculate this misalignment? It relies not on Big Macs, but on the less digestible methods favoured by the IMF. The fund uses three related approaches. First, it calculates the real exchange rate that would steadily bring a country’s current-account balance (equivalent to the trade balance plus a few other things) into line with a “norm” based on the country’s growth, income per person, demography and budget balance.
The fund’s second approach ignores current-account balances and instead calculates a direct statistical relationship between the real exchange rate and things like a country’s terms of trade (the price of its exports compared with its imports), its productivity and its foreign assets and liabilities. The strength of Brazil’s currency, for example, may partly reflect the high price of exports such as soyabeans (Soja).
Third, the fund also calculates the exchange rate that would stabilise the country’s foreign assets and liabilities at a reasonable level. If, for example, a country runs sizeable trade surpluses, resulting in a rapid build-up of foreign assets, it probably has an undervalued exchange rate.
The IMF has typically assessed its members’ policies one at a time. But the fund’s managing director, Dominique Strauss-Kahn, now proposes to assess its biggest members all at once to make sure their macroeconomic strategies do not work at cross-purposes. He is keen to identify the ways in which a country’s policies, including its exchange-rate policies, “spill over” to its neighbours.
Those spillovers depend on the size of the economy as much as the scale of any misalignments. But the biggest economies are also the hardest to bully. The fund’s last annual report on the Chinese economy, in July, included the government’s rebuttal of every criticism the fund offered. In a decorous compromise the report concluded that the yuan was “substantially” undervalued but refrained from quantifying the size of the problem.
Big revaluations of the kind required to satisfy the fund or equalise the price of burgers are unlikely. A recent study of the Big Mac index by Kenneth Clements, Yihui Lan and Shi Pei Seah of the University of Western Australia showed that misalignments are remarkably persistent. As a result, the raw index did a poor job of predicting exchange rates: undervalued currencies remain too cheap and overvalued currencies remain too pricey.
But since this bias is systematic, it can be identified and removed. Once that is done, the three economists show that a reconstituted index is good at predicting real exchange rates over horizons of a year or more. Since The Economist costs just $6.99 (a little less than two burgers) on the news-stand, the index provides decent value for money for would-be currency speculators, the authors conclude. The Big Mac index may itself be undervalued.