Economics focus The Big Mac index

Document Sample
Economics focus The Big Mac index Powered By Docstoc
					Economics focus: The Big Mac index                                    All the emerging-market currencies are undervalued against the
                                                                      dollar on a Big Mac PPP basis. That, in turn, means that a
Big Mac Currencies                                                    currency such as Argentina’s peso, which is undervalued only a
Apr 19th 2001                                                         tad against the dollar, is massively overvalued compared with
From The Economist print edition                                      other currencies, such as the Brazilian real and virtually all of the
                                                                      East Asian currencies.
The Economist’s Big Mac index of currencies offers food for
thought                                                               Some of our readers find the Big Mac index hard to swallow. Not
                                                                      only does the theory of purchasing-power parity hold only for the
IT IS time for our annual bite at burgernomics. The Economist’s       very long run, but hamburgers are a flawed measure of PPP.
Big Mac index was first launched in 1986 as a gastronome’s            Local prices may be distorted by trade barriers on beef, sales
guide to whether currencies were at their correct exchange rate. It   taxes, or big differences in the cost of property rents.
is not intended to be a precise predictor of currency movements,      Nevertheless, some academic studies of the Big Mac index have
but simply a way to make exchange-rate theory a bit more              concluded that betting on the most undervalued of the main
digestible.                                                           currencies each year is a profitable strategy.

Burgernomics is based upon one of the oldest concepts in
international economics: the theory of purchasing-power parity
(PPP). This argues that the exchange rate between two currencies
should in the long run move towards the rate that equalises the
prices of identical bundles of traded goods and services in each
country. In other words, a dollar should buy the same amount

Our “bundle” is a McDonald’s Big Mac, which is produced to
more or less the same recipe in about 120 countries. The Big Mac
PPP is the exchange rate that would leave hamburgers costing the
same in each country. Comparing a currency’s actual exchange
rate with its PPP is one test of whether the currency is
undervalued or overvalued.

The first column of the table shows local-currency prices of a Big
Mac; the second converts them into dollars. The average price of
a Big Mac in America is $2.54 (including sales tax). In Japan,
Big Mac scoffers have to pay ¥294, or $2.38 at current exchange
rates. The third column calculates PPPs. Dividing the yen price
by the dollar price gives a Big Mac PPP of ¥116. Comparing that
with this week’s rate of ¥124 implies that the yen is 6%

The cheapest Big Macs are found in China, Malaysia, the
Philippines and South Africa, and all cost less than $1.20. In
other words, these countries have the most undervalued
currencies, by more than 50%. The most expensive Big Macs are
found in Britain, Denmark and Switzerland, which by implication
have the most overvalued currencies. Sterling, for example is
12% overvalued against the dollar—less than two years ago, it
was overvalued by 26%.

The greatest triumph of the Big Mac index has been in tracking
the euro. When Europe’s new currency was launched in January
1999, virtually everybody predicted that it would rise against the
dollar. Everybody, that is, except the Big Mac index, which
suggested that the euro started off significantly overvalued. One     McCurrencies
of the best-known hedge funds, Soros Fund Management,                 Apr 24th 2003
admitted that it chewed over the sell signal given by the Big Mac     From The Economist print edition
index when the euro was launched, but then decided to ignore it.
The euro tumbled; Soros was cheesed off.                              THE past year has been one to relish for fans of burgernomics.
                                                                      Last April The Economist's Big Mac index flashed a strong sell
The average price today in the 12 euro countries is euro2.57, or      sign for the dollar: it was more overvalued than at any time in the
$2.27 at current exchange rates. The euro’s Big Mac PPP against       index's history (see article). The dollar has since flipped, falling
the dollar is euro1=$0.99, which shows that it has now undershot      by 12% in trade-weighted terms.
McParity by 11%. That, in turn, implies that sterling is 26%
overvalued against the euro.                                          Invented in 1986 as a light-hearted guide to whether currencies
                                                                      are at their “correct” level, burgernomics is based on the theory
Overall, the dollar has never looked so overvalued during 15          of purchasing-power parity (PPP). This says that, in the long run,
years of burgernomics. In the mid 1990s the dollar was cheap          exchange rates should move toward rates that would equalise the
against most currencies; now it looks dear against all but three.     prices of an identical basket of goods and services in any two
The most undervalued of the rich-world currencies are the             countries. To put it simply: a dollar should buy the same
Australian and New Zealand dollars, which are both 40-45%             everywhere. Our basket is a McDonald's Big Mac, produced
below McParity. They need to ketchup.                                 locally to roughly the same recipe in 118 countries. The Big Mac
                                                                      PPP is the exchange rate that would leave burgers costing the
same as in America. Comparing the PPP with the actual rate is
one test of whether a currency is undervalued or overvalued.

The first column of the table shows local-currency prices of a Big
Mac. The second converts them into dollars. The average price of
a Big Mac in four American cities is $2.71. The cheapest burgers
are in China ($1.20); the dearest are in Switzerland ($4.52). In
other words, the yuan is the most undervalued currency, the
Swiss franc the most overvalued. The third column calculates Big
Mac PPPs. Dividing the local Chinese price by the American
price gives a dollar PPP of 3.65 yuan. The actual exchange rate is
8.28 yuan, implying that the Chinese currency is undervalued by
56% against the dollar. The average price of a Big Mac in the
euro area is now exactly the same as in America. This implies
that the euro's PPP is exactly $1, so at its current rate of $1.10 the
euro is 10% overvalued. The British, Swedish and Danish
currencies are still significantly overvalued against the euro.

Among rich economies, the most undervalued currency is the
Australian dollar. The Aussie dollar is still 31% below PPP
against its American counterpart: its rise over the past year has
been largely offset by a fall in the relative price of burgers in
Australia. Many emerging-market currencies are undervalued
against the dollar by 30-50%. One exception is the South Korean
won, which is exactly at its PPP, implying that it is overvalued
against other emerging-market currencies.

Many readers complain that burgernomics is hard to swallow.
We admit it is flawed: Big Macs are not traded across borders as
the PPP theory demands, and prices are distorted by taxes, tariffs,
different profit margins and differences in the cost of non-
tradables, such as rents. It was never intended as a precise
predictor of currency movements, but as a tool to make
exchange-rate theory more digestible. Yet in the early 1990s, just
before the crisis in Europe's exchange-rate mechanism, it
signalled that several currencies, including sterling, were
markedly overvalued against the D-mark. It also predicted the
fall in the euro after its launch in 1999.

Academic economists are taking burgernomics more seriously,
chewing over the Big Mac index in almost a dozen studies. Now
a whole book has been written about the index by Li Lian Ong,
of the International Monetary Fund. She says it has been
surprisingly accurate in tracking exchange rates in the long term.
But there are some persistent deviations from PPP. In particular,
emerging-market currencies are consistently undervalued.

Differences in productivity are one explanation of this. Rich
countries have higher productivity than poor countries, but their
advantage tends to be smaller in non-tradable goods and services
than in tradables. Because wages are the same in both sectors,
non-tradables are cheaper in poorer countries. Therefore, if
currencies are determined by the relative prices of tradables, but
PPP is calculated from a basket that includes non-tradables, such
as the Big Mac, the currencies of poor countries will always look
undervalued. Ms Ong finds that currency deviations from PPP
are indeed related to productivity differences relative to America.
After adjusting for this, she finds that the Big Mac index
performs better in tracking exchange rates.

The Big Mac index suggests that the dollar is no longer
overvalued against the euro. But having overshot PPP, the dollar
may well now undershoot, because America's huge current-
account deficit is becoming harder to finance. Without stronger
domestic demand in Japan and Europe to help trim the deficit, the
dollar will have to take more of the strain. What are this year's
other hot tips? The Australian dollar is likely to see the biggest
gain. The pound will fall further against the euro. And China will
come under increasing pressure to revalue the yuan.

Shared By: