Yuan undervalued - Big Mac Index

There are a lot of novel ways to measure various economic statistics, but not is more intuitive and universally accepted than the “Big Mac Index”.

According to The Economist, the index is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.

Recent rhetoric has been centered on the accusation that China is a “currency manipulator”. In this article by The New York Times, the paper says:

“China’s decision to base its economic growth on exporting deliberately undervalued goods is threatening economies around the world. It is fueling huge trade deficits in the United States and Europe. Even worse, it is crowding out exports from other developing countries, threatening their hopes of recovery.”

“After treading lightly on the subject of China, President Obama vowed last month to ‘get much tougher’ about China’s cheap currency. On Monday, 130 members of Congress sent a letter to Treasury Secretary Timothy Geithner, demanding that the Obama administration designate China as a currency manipulator in a report due to Congress next month. On Tuesday, a bipartisan group of senators introduced a bill aimed to force the administration’s hand. This would ease the way to imposing retaliatory trade barriers against Chinese goods.”

As a result Chinese officials are travelling to Washington to dispute the allegations. Chinese Premier Wen Jiabao last week denied that the yuan is undervalued. "A lot of problems can be properly solved so long as we can avoid politicization and emotionalization," China's commerce minister He Ning told reporters.

So back to the question: just how undervalued is the Chinese currency in relation to the Dollar? The Economist has a wonderful graphic (click here to see it) representing the findings of their research using the Big Mac Index. On this measure, the yuan is about 50% undervalued against the dollar.

The graphic also shows that the euro is about 27% overvalued while the Norwegian krone is close to 90% overvalued. There’s been a lot of discussion about the euro versus the dollar. Interestingly all 5 of the most undervalued currencies are Asian nations, while the South African rand, which is one of the top two performing currencies against the dollar over the past year, is still more than 25% undervalued.

The Big Mac Index is obviously a crude measure of value but historically has proven surprisingly accurate at finding currencies that are out of line and henceforth trend to equilibrium.

Originally published by me at BestCashCow.com (link)