Big Mac Index says Rand still Undervalued

A weak currency, despite its appeal to exporters and politicians, is no free lunch. But it can provide a cheap one. In China 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 the same burger averages $3.71. That makes China’s yuan one of the most undervalued currencies in our Big Mac index, which is based on the idea of purchasing-power parity.

This 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. At just $0.15, it is undervalued by about 40%. The tensions caused by currency misalignments prompted Brazil’s finance minister to complain last month that his country was a potential casualty of a “currency war”. The Swiss, who avoid most wars, are in the thick of this one. Their franc is the most expensive currency on our list.

Source: The Economist

Why China Insists on Controlling its Currency

U.S.-Chinese relations have become tenser in recent months, with the United States threatening to impose tariffs unless China agrees to revalue its currency and, ideally, allow it to become convertible like the yen or euro. China now follows Japan and Germany as one of the three major economies after the United States. Unlike the other two, it controls its currency’s value, allowing it to decrease the price of its exports and giving it an advantage not only over other exporters to the United States but also over domestic American manufacturers. The same is true in other regions that receive Chinese exports, such as Europe.

What Washington considered tolerable in a small developing economy is intolerable in one of the top five economies. The demand that Beijing raise the value of the yuan, however, poses dramatic challenges for the Chinese, as the ability to control their currency helps drive their exports. The issue is why China insists on controlling its currency, something embedded in the nature of the Chinese economy. A collision with the United States now seems inevitable. It is therefore important to understand the forces driving China, and it is time for STRATFOR to review its analysis of China.

An Inherently Unstable Economic System

China has had an extraordinary run since 1980. But like Japan and Southeast Asia before it, dramatic growth rates cannot maintain themselves in perpetuity. Japan and non-Chinese East Asia didn’t collapse and disappear, but the crises of the 1990s did change the way the region worked. The driving force behind both the 1990 Japanese Crisis and the 1997 East Asian Crisis was that the countries involved did not maintain free capital markets. Those states managed capital to keep costs artificially low, giving them tremendous advantages over countries where capital was rationally priced. Of course, one cannot maintain irrational capital prices in perpetuity (as the United States is learning after its financial crisis); doing so eventually catches up. And this is what is happening in China now.

STRATFOR thus sees the Chinese economic system as inherently unstable. The primary reason why China’s growth has been so impressive is that throughout the period of economic liberalization that has led to rising incomes, the Chinese government has maintained near-total savings capture of its households and businesses. It funnels these massive deposits via state-run banks to state-linked firms at below-market rates. It’s amazing the growth rate a country can achieve and the number of citizens it can employ with a vast supply of 0 percent, relatively consequence-free loans provided from the savings of nearly a billion workers.

It’s also amazing how unprofitable such a country can be. The Chinese system, like the Japanese system before it, works on bulk, churn, maximum employment and market share. The U.S. system of attempting to maximize return on investment through efficiency and profit stands in contrast. The American result is sufficient economic stability to be able to suffer through recessions and emerge stronger. The Chinese result is social stability that wobbles precipitously when exposed to economic hardship. The Chinese people rebel when work is not available and conditions reach extremes. It must be remembered that of China’s 1.3 billion people, more than 600 million urban citizens live on an average of about $7 a day, while 700 million rural people live on an average of $2 a day, and that is according to Beijing’s own well-scrubbed statistics.

Moreover, the Chinese system breeds a flock of other unintended side effects.

Read STRATFOR's Full Article Here

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)