The Economist’s Big Mac Index

The Economist’s exchange-rate scorecard, the Big Mac index – based on the theory of purchasing power parity which argues that in the long run exchange rates should move to equalise the price of an identical basket of goods between two countries – shows that currencies continue to be cheap in the developing world but overvalued in Europe.

This is a sensitive topic given that the US maintains that Beijing’s “manipulation” of its currency has hurt American businesses, and contributed majorly to the financial crisis. The ‘global imbalances’ that have resulted from the undervaluation of Asian currencies – a large US trade deficit resulting in huge Chinese US dollar reserves that are recycled by buying Treasury bonds – have yet to be addressed; despite US Secretary of the Treasury Geithner and the Obama administration adopting a somewhat confrontational stance towards China’s economic policies during the election campaign. Ironically enough, Asia’s determination to maintain large currency reserves are a lesson they learnt from the IMF’s uncomprimsing response to the Asian currency crisis of ’97, one of the authors of which, was Mr. Geithner.

In its latest update, The Economist’s Big Mac index shows that China’s yuan is one of the most undervalued currencies in the Big Mac index, while Switzerland is one of the most overvalued – by as much as 80%.

However the ‘currency war’ between the U.S. and China works out, you don’t want to be holding Swiss Francs for the long term it seems. Once the global economy recovers it will collapse as safe haven flows reverse.