The Big Mac index: An indigestible problem

* Author: The Economist

Why China needs more expensive burgers Oct 14th 2010 Hong Kong

( 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.

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.