January 1, 2008


Why the difference of opinion when it comes to how much the Chinese yuan is undervalued?


By now, many in the North American manufacturing community are of one accord when it comes to the Chinese yuan: It’s vastly undervalued and contributing to catastrophic trade imbalances here. It’s clear the yuan has appreciated only slightly since July 2005, when China ended its practice of pegging its currency to the U.S. dollar—just an 8.8% appreciation from July 2005 to October 2007, the Federal Reserve reports.

But how much the yuan is undervalued depends on whom you ask and what method is used. Generally, economists rely on one of three methods to value currency:

Purchasing Power Parity (PPP)—This method is based on the theory of “one price.” It determines the exchange rate that equates the price of identical traded goods in two countries. But it sparks some criticism: Prices of the same product may vary from region to region within the same country, and they also depend on supply and demand.

The Economist’s Big Mac Index is based on the PPP theory. It compares currencies on a PPP basis and determines the exchange rate that makes the U.S. dollar price of McDonald’s Big Mac hamburger the same in each country. The July 2007 Big Mac Index reported the yuan, the most extreme currency, is undervalued by 58%. But the index considers only one good—albeit one sold in more than 100 countries—and does not bear in mind such things as taxes, tariffs and even rent.

Behavioral Equilibrium Exchange Rate (BEER)—This approach estimates the level to which the market exchange rate is expected to revert in the future, assuming the currency on average was in equilibrium over the period of estimation. But this method, too, has its critics, including the Peterson Institute for International Economics’ William R. Cline and John Williamson, who in an October 2007 report wrote, “A problem with some BEER estimates is that they are calculated from a regression for a single country rather than from cross-country experience. Such studies are surely incapable of examining whether a country’s policy intervention is or is not making the country over- or undervalued.”

Ronald MacDonald and Preethike Dias, in a 2007 paper prepared for the Peterson Institute, computed the undervaluation rate of the yuan at between 27.3% and 46.6% using a BEER model. With a sample period from first-quarter 1998 to first-quarter 2006, they estimated BEERs for the effective exchange rates of 10 industrialized nations, including the United States, China, Japan and the U.K. The study used several data fields, including countries’ real effective exchange rate, net exports, terms of trade differential and GDP per capita differential.

Fundamental Equilibrium Exchange Rate (FEER)—This method, emphasizing that an exchange rate should not be determined by temporary market equilibrium, looks for a set of exchange rates that will achieve both internal—such as noninflationary full employment—and external balance. The controversy lies in determining what exactly that external balance means.

In 2007, based on a FEER model, Morris Goldstein and Nicholas Lardy, both senior fellows at the Peterson Institute, estimated the needed appreciation to eliminate undervaluation at between 35% and 60%. Their method uses an elasticity approach, which emphasizes price changes to determine a country’s balance of payments and exchange rates. They suggest that each 10% change in China’s real effective exchange rate is associated with a change of 2% to 3.5% of GDP in China’s global trade balance.

Regardless of how the yuan’s valuation is calculated, immediate action is needed. “The pace of appreciation [of the yuan] is grossly inadequate,” Lardy says.