Purchasing Power Parity and value of the Chinese Renminbi

The sentence that I find most interesting in the following report from Bloomberg is where Mr Geithner is reported as saying

“We welcome China’s fiscal measures and continued commitment to move to a more flexible exchange rate, which should lead to continued appreciation of the Renminbi,”

I'd like to know more about how that works. And I'd like to know how China is supposed to have been keeping the value of the Yuan low - which it has been accused of doing. Not that I am saying it has not done that, or that I am casting doubt on its ability to do that. I'd just like to know how a country does that.

There is a Wikpedia article on the subject of purchasing power parity.

The opening paragraphs of the article state that:

The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. Developed by Gustav Cassel in 1920, it is based on the law of one price: the theory states that, in ideally efficient markets, identical goods should have only one price.
This purchasing power exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. 

As the article says, and quite rightly it seems to me, PPP is based on the notion that goods have equal value in the eyes of the population in the countries being compared. And this is clearly not the case in countries as different as say China and the United States.

Which calls to mind the news item I saw on CNN Asia a couple of weeks ago that described how a very large number of small companies in China had gone into bankruptcy on account of the global downturn in trade, but that the bigger companies would be able to ride out the storm.

The news report was read out over a scene of the assembly line at a factory that was described as being one of those large companies that represented the real power of China's output. And what was it making? - black and white stuffed toys.

I remember thinking at the time it was laughable and sad to think that China's economy and its contribution to world economic stability was based in part on its ability to maintain output of fluffy toys.

But the point is, how could anyone possibly compare the value a soft toy has to someone in China and that value it has to someone in the United States?

And without that, purchasing power parity has limited meaning.

Reported at Bloomberg By Steve Scherer
Feb. 14 (Bloomberg) -- Group of Seven finance chiefs eased their criticism of China’s exchange-rate policy as the world’s most populous country moved to bolster its economy during the global recession.

Less than a month ago, U.S. Treasury Secretary Timothy Geithner, who attended today’s meeting in Rome, said President Barack Obama thought that China was “manipulating its currency.”

“We welcome China’s fiscal measures and continued commitment to move to a more flexible exchange rate, which should lead to continued appreciation of the Renminbi,” the G- 7 said today in its final communiqué.

China announced 4 trillion yuan ($585 billion) in spending in November to support the economy amid the global recession. China, the world’s second-biggest energy consumer, may approve a stimulus plan for the oil refining and petrochemicals industries by next week to help spur the slowing economy, two industry officials said yesterday.

“We very much welcome the steps they’ve taken to strengthen domestic demand, and welcome” China’s commitment to exchange rate reform, Geithner told reporters today in Rome, a view echoed by French Finance Minster Christine Lagarde.

“The more conciliatory tone on China is the key departure from previous statements,” Geoffrey Yu, a London-based foreign-exchange strategist at UBS AG, said in an e-mailed statement. “The G-7 has realized that China needs to be brought into the fold of the global financial system rather than be treated as a pariah just because of yuan inflexibility.”

Shifting Position

Since first describing flexible exchange rates as “desirable” after a 2003 meeting in Dubai, the G-7 has swung between pressuring and praising China’s exchange rate policy.

Having cheered a July 2005 revaluation, the officials said the following December that further shifts would aid the world economy and four months later said China “especially” should adjust its currency.

In February 2007 the G-7 encouraged the yuan to “move” more on a trade-weighted basis and at the three meetings between October 2007 and last April pressed China to allow an “accelerated appreciation.”