Sunday, June 12, 2005

Big Mac Index & China

The Economist has released Big Mac Index 2005. For those of you not familiar with the concept, a pair of Wikipedia links are in order: The Big Mac Index is a measure of Purchasing Power Parity (PPP). Since the article accompanying this year's index doesn't explain it well, allow me to quote the explanation with the 2004 Index:
How fast is the world economy growing? How important is China as an engine of growth? How much richer is the average person in America than in China? The answers to these huge questions depend crucially on how you convert the value of output in different countries into a common currency. Converting national GDPs into dollars at market exchange rates is misleading. Prices tend to be lower in poor economies, so a dollar of spending in China, say, is worth a lot more than a dollar in America. A better method is to use purchasing-power parities (PPP), which take account of price differences.
Using a Big Mac to measure PPP may seem too simple to be real economics, but in fact it is one of the most accurate measures of PPP. Why? The Big Mac's ingredient list (two all beef patties, special sauce, lettuce, cheese, pickles, onions on a sesame seed bun) is the perfect identical "basket of goods." Again from the 2004 writeup:
The theory of purchasing-power parity says that in the long run exchange rates should move towards rates that would equalise the prices of an identical basket of goods and services in any two countries. This is the thinking behind The Economist's Big Mac index. Invented in 1986 as a light-hearted guide to whether currencies are at their “correct” level, our “basket” is a McDonalds' Big Mac, which is produced locally in almost 120 countries.
For those of you who need formulas and economics jargon to trust its authenticity, you can find a research paper on the subject here (PDF).
The impetus for the economics lesson is one of The Economist's conclusions (from this year's report):
If he could keep the burgers fresh, an ingenious arbitrageur could buy Big Macs for the equivalent of $1.27 in China, whose yuan is the most undervalued currency in our table, and sell them for $5.05 in Switzerland, whose franc is the most overvalued currency.

Why Does It Matter?
The proper exchange rate between the yuan and the dollar has been a hot topic of conversation in the last year. The finding that the yuan is "the most undervalued currency" of the nearly seventy studied should support the American position. Many, including some American politicians, have blamed the exchange rate being favorable to Chinese exports as a cause of the large, and growing, trade imbalances between the two nations.
What Do We Do (If Anything)?
Senator Charles Schumer (D, NY) has been most vociferous in criticizing the policy and has offered a solution. According to the WaPo article:
Schumer is co-author of a bill that threatens China with a 27.5 percent across-the-board tariff on U.S. imports of Chinese goods if it does not revalue its currency, the yuan.
Could such a bill pass? Is there support for it in the Senate? Again from the WaPo article:
That measure attracted 67 votes in the Senate this year before it was withdrawn. Schumer and Sen. Lindsey Graham, a South Carolina Republican, have been promised a second vote on the bill before the end of July.
The popularity of this bill has led The Economist to wonder if Congress is turning protectionist. As The Economist article points out:
Not only is the legislation utterly against WTO rules, it would cause havoc for the American economy. But Mr Schumer has been promised a vote by July, and his bill may well pass the Senate.
Whether in the form of this bill or some other coercive measure, it appears the United States is determined to have China revalue its currency. But that just brings about another question...
Will It Solve The Problem?
According to the Cleveland Fed's Economic Trends report (pdf) answering this question involves "non-deliverable forwards." Since I haven't a clue what that means, I will just quote from another part of the report:
The question, of course, is in what direction and to what degree the currencies will depart from the present fixed exchange rate, when - and if - the Chinese government alters the peg. Some market observers are convinced... (emphasis added)
I take that to mean that they don't know the answer either.
Will There Be Side-Effects?
There is a twist to this talk of cheap exports (as explained by The Economist):
Today, America is the world's biggest debtor, with China as an important creditor. A sharp reversal in China's appetite for American Treasury bonds could send interest rates soaring.
For a worst-case scenario of where such a loss of appetite would lead, I refer you to Paul Krugman:
Here's what I think will happen if and when China changes its currency policy, and those cheap loans are no longer available. U.S. interest rates will rise; the housing bubble will probably burst; construction employment and consumer spending will both fall; falling home prices may lead to a wave of bankruptcies. And we'll suddenly wonder why anyone thought financing the budget deficit was easy.

Others have speculated that China would just be opening itself up to currency speculation, which has been a dirty word in Asia since 1997. Hong Kong's The Standard offers a solution to the latter problem: pegging the yuan to gold.
And now for a few extra links that just didn't fit in the above:
In a post entitled "Reevaluating a Renminbi Revaluation," Cynic's Delight points out that in addition to the peg, we should be watching the rates of inflation inside China.
To keep track of this issue in the days and weeks ahead, just click here for all the latest courtesy of Google News.
My conclusion is that I don't know the answer. Therefore, my question to you, my wonderful readers, is two-fold: (A) Is this really a problem? Phrased more generally, is a trade deficit inherently bad? (B) What, if anything, should be done about it?

  • The Economist has an article (subscription required) wondering if the yuan isn't as undervalued as we think. Excerpt:
    Using a range of yardsticks, the International Monetary Fund reckons, like the BEER studies, that it is hard to find strong evidence that the yuan is much undervalued.
  • Wen Jiabao says no to revaluation.
  • Senators back down.