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By Annaly Capital Management:

More skirmishes broke out in the exchange rate war between the US and China since our last post on the topic on March 12. On Sunday March 14, Premier Wen Jiabao told the world to butt out. “First of all, I do not think the renminbi is undervalued,” Mr. Wen said. “We are opposed to the practice of mutual finger pointing among countries or taking strong measures to force other countries to appreciate their currencies. To do this is not beneficial to reform of the renminbi exchange-rate regime.” Mr. Wen was speaking at a press conference following the close of China’s legislative session. He went on to say, “What I don’t understand is depreciating one’s own currency and pressing other countries to appreciate their own currencies just for the sole purpose of increasing their trade. In my opinion this is trade protectionism.” On Tuesday March 16, Congress responded with real protectionism in a bipartisan Senate bill to require the US to use tariffs and other penalties against currency manipulators such as China. The House Ways and Means Committee called for hearings on March 24 on China’s currency policy.

Treasury is due to release its semi-annual report on foreign exchange rate practices on April 15. While there is certainly pressure to do so-a bipartisan group of 130 Congressmen sent a letter to Treasury Secretary Geithner last week, urging him to get tougher on China-it is unlikely that China will be branded a currency manipulator. It would largely be counterproductive, as they don’t respond well to pressure.

Nevertheless, as policymakers wrangle over this issue, we urge them to take note of the following. For years now, the Economist has kept tabs on purchasing power parity through the price of a near global commodity, the Big Mac, which is produced in about 120 countries. As the magazine says, “It is arguably the world’s most accurate financial indicator to be based on a fast-food item.” Purchasing power parity suggests that a dollar should buy the same amount in all countries, and comparing the Big Mac price in dollar terms in different countries is one way to determine whether or not there is PPP. Below we graph a few of these data points.

Click Here to Enlarge Chart

According to the most recent survey published on March 17, a Big Mac in the US costs $3.58 (an average of the price in four cities). In China, the same burger will cost you $1.83, indicating the renminbi is 49% undervalued, the most of 22 countries or regions in the survey. But some progress is being made; in 2005 the renminbi was undervalued by 59%. A dollar is 29% undervalued in Europe, where it will cost you $4.62 for those two all-beef patties (a weighted average of member countries).

Here’s a modest proposal: Americans and Europeans should go to China, buy up all the Big Macs in local currency and then bring them home for resale.

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