The Big Mac Index

I attended a party at which a currency trader proclaimed that the low price of a Big Mac in China was conclusive evidence that the Chinese currency was undervalued by 50%.

As many know, the 'Big Mac index' compares the price of a Big Mac in different countries to indicate the purchasing power of respective currencies. Most investors would probably not sink their savings into currency speculation on the strength of it – especially if they were aware of a similar survey, known as the 'Starbucks index', that found the Chinese currency is not undervalued at all.

Of course these surveys are more reflective of the respective companies' business and pricing strategies than anything else. But they do raise the question of whether China's currency is in fact unfairly undervalued.

Japan, the European Union and the United States have all been outspoken in calling for China to revalue the yuan, which is essentially pegged at 8.28 to the US dollar. They contend that China receives unfair advantage by keeping its currency artificially low in order to promote cheap exports. China itself says that although it intends to eventually move to a floating currency determined by market forces, its currency is not radically undervalued. Besides, they say, adjusting will not necessarily achieve desired results such as reducing the US current account deficit and China's financial system is not in any case yet robust enough to deal with shocks caused by drastically altering its foreign exchange mechanisms.

A look at history
Some historical context might be helpful here. China's fixed-rate exchange system was established in 1994. The first time anyone raised the issue of an undervalued Chinese currency was in the second half of 2002. Until then capital flight and black market rates indicated that the RMB was overvalued. During the Asian financial crisis in the late 1990s, the world hailed China for resisting pressures to devalue its currency. Essentially, China's fixed exchange rate has been overvalued, hurting exports for more than seven years, and allegedly undervalued for less than three. Many analysts agree that the yuan is undervalued to a degree but even that can be disputed. Much of the pressure for the RMB to appreciate has come from speculative flows of 'hot money' into the country from international currency traders. If the currency were revalued, much of this speculative money would likely flow back out of the country as traders cashed in their chips and took their profits home – causing the yuan to depreciate.

Prime Minister Wen Jiabao has said China would not revalue under duress. "Honestly speaking, the more speculation there is, the more unlikely it is that the necessary measures can be undertaken," he said.

Chinese economic officials prefer to talk now about revaluation, but about gradually introducing more flexibility to the system. In the last months of 2004 Beijing announced a series of initiatives to relax capital outflows in what some see as a precursor to a wider trading band for the yuan.

At present, China's capital account is closed, which means that (especially outbound) capital and investment cannot flow freely across the country's borders. Anyone who has lived in China knows the problems of trying to change RMB into foreign currency. A freely floating currency would need an open capital account and that would probably result in an outflow of a significant portion of the RMB 18trn held by non-state entities and individuals in the China's fragile state banks. Assuming that exodus did not bring down the entire financial system, it would cause the yuan to depreciate rather than appreciate – a scenario that would suggest the currency is not necessarily undervalued.

Exchange rates are based theoretically on the balance of trade and one of the main arguments for the appreciation of China's currency is the estimated US$120bn surplus it has with the US. But overall, China actually saw a small deficit (about US$1 billion more imports than exports) for the first eight months of 2004.

IMF's tempered view
The International Monetary Fund (IMF) has dismissed assertions that the yuan is misaligned with other currencies. Even Washington-based Institute for International Economics (IIE), a leading proponent of revaluation, suggests the yuan is undervalued by 10 to 20%, pointedly not the 30-40% claimed by many US politicians.

Predicting how currency markets will play out is a risky business, but here goes: "Cautious" and "incremental" are the key words when it comes to shifts in Chinese economic policy, so a sudden move to a fully convertible floating currency is out of the question.

With so much uncertainty over whether the yuan really is undervalued it is unlikely that the central bank will opt for a one-off revaluation as some observers have suggested.

The government says it is a case of when, not if, the exchange rate will be liberalized. The most likely scenario: China widens the current trading band to plus or minus 3% either side of RMB 8.28 to the US dollar, and then at a future date moves to a trade-weighted basket of currencies. The eternally self-assured investment bank Goldman Sachs says it will happen in the first quarter of this year, but they said the same thing last year.

One thing is certain: you won't find out by checking the price of a Big Mac.