More inflation warnings on Wednesday in China, this time from a highly symbolic source. The price of a Big Mac has risen from Rmb14 to Rmb15 at the branch of McDonald’s around the corner from the FT’s Beijing bureau - part of an across-the-board price hike that the US fast food chain blamed on rising costs of ingredients - even if that is still less than two-thirds of the price of a Big Mac in the US.
Why has the price of a Big Mac gone up? Why, indeed, are many prices in China going up? Can the root cause be explained by the Big Mac index, which shows the RMB is undervalued by 40%? The article states
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...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%.
You'll notice that the national average price of a Beijing Big Mac was 14.5 RMB in October, so hungry staffers at the Economist Magazine were actually getting a bit of a deal. In London, the research team tells reported that, taking into account the price, increase the yuan is now undervalued by just...39%.
Markets have been signalling for years that the Chinese currency really ought to appreciate. If the adjustment isn't made through the nominal exchange rate, then it will occur through the real exchange rate, via increases in the price level.
Now the WSJ chimes in with the ipod-index... - is that a better way to examine the implications of the law of one price?