Invest with the Big Mac Index 2.0

08/10/2011 12:30 pm EST

Focus: MARKETS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

It is the 25th year running that The Economist has published its famed Big Mac Index—a tongue-in-cheek way of measuring purchasing power parity (PPP)—that is, the relative over- and undervaluation of the world’s currencies, observes Nicholas Vardy of The Global Guru.

It is the 25th year running that The Economist has published its famed Big Mac Index—a tongue-in-cheek way of measuring purchasing power parity (PPP)—that is, the relative over- and undervaluation of the world’s currencies.

According to the theory of purchasing power parity, a dollar should buy the same amount of the same good across all countries. As a result, in the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country.

By comparing the cost of Big Macs—a good produced in about 120 countries—the Big Mac Index calculates the exchange rate (the Big Mac PPP) that would result in hamburgers costing the same in the United States as they do abroad.

Compare the Big Mac PPP to the market exchange rates, and voilà!…you see which currencies are under- or overvalued.

This year, a "new" version of the Big Mac Index also provides some surprising insights on the relative valuations of the currencies of the world’s two biggest economies, the United States and China.

By understanding which global currencies are over- and undervalued, you can construct—and profit from—your very own global currency portfolio.

The "Big Mac" Index Makes it Big
Although it started out as a tongue-in-cheek indicator, it’s surprising how seriously some governments now take the Big Mac Index. There are even (unconfirmed) reports that the Argentine government subsidizes the price of the Big Mac to suppress officially calculated rates of inflation.

The Big Mac Index also provides a snapshot on global inflation versus official government statistics. For instance, the price of a Big Mac in the United States is up a whopping 9.1% compared to this time last year. That’s more than double the inflation rate calculated by the US Consumer Price Index.

Granted, the Big Mac Index is far from perfect. Because of varying labor and input costs, the Index is most valuable when comparing countries at roughly the same stage of development. The thinking is that average prices are lower in poor countries than in rich ones because labor costs are lower.

Indeed, there is a strong positive relationship between the dollar price of a Big Mac and GDP per person. That’s why this year—for the first time ever—The Economist also calculated PPP adjusted for per-capita GDP.

The "Old" Big Mac Based on PPP
This year, only a handful of currencies are within 10% of their Big Mac PPP value—and they are as far-flung as the United Kingdom, Chile, Czech Republic, Hungary, Japan, New Zealand, and Turkey.

With the British pound depreciating and the Japanese yen appreciating over the past few years, the PPP values of some of the most-traded currencies in the world are as in line as they have been in recent memory.

As always, the most overvalued currencies are in Western Europe. As a group, the Scandinavian currencies are by far the most overvalued currencies in the world. A Big Mac in Oslo, Norway, where the currency is overvalued by 104%, will cost you twice as much as in the United States.

Three years ago, the euro was overvalued by a massive 50% compared to the US dollar. Today, that figure is down to 21%. Thanks to its soaring appreciation as a "safe-haven" asset, the Swiss franc is overvalued by 98% against the dollar.

The most undervalued currencies are in Asia. The Hong Kong dollar (which, curiously enough, is linked to the US dollar) is by far the most undervalued currency in the world, undervalued by 53%.

Malaysia, the Philippines, Thailand, and Indonesia remain about 30% to 40% undervalued. The Chinese yuan remains 44% below its PPP rate—the recent "flexibility" of the Chinese government’s approach to the yuan notwithstanding.

A Big Mac costs $2.27 in China at current exchange rates, versus $4.07 at your local mall in Ohio. This confirms that China’s cheap currency acts as a massive subsidy to Chinese exports.

Commodities-based currencies in Australia and Canada are more than 20% overvalued. The biggest surprise is Brazil, which has attracted oodles of "hot money." Last year, the Big Mac Index showed that Brazil was 31% overvalued. Today, that number has risen to an eye-popping 52%.

NEXT: The New Big Mac Index—Adjusted for GDP

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The New Big Mac Index—Adjusted for GDP
According to exchange-rate theory, PPP signals where exchange rates should move in the long run. But the short term can vary considerably.

To estimate the current fair value of a currency, The Economist used the "line of best fit" between Big Mac prices and GDP per person. This is a blunt tool indeed, but calculating the difference between the price predicted for each country, given its average income, and its real price, is perhaps a better guide to the current value of the currency.

Several things jump out at you, using this measure.

Thanks to the appreciation of the Brazilian real during the past year, the real is now overvalued by an astonishing 149%. That makes it the most overvalued currency in the world.

The Swiss franc or Scandinavian currencies are still remarkably overvalued—although several Eastern European and Latin American currencies are giving them a run for their money. The euro is still 36% overvalued against the dollar.

The two biggest surprises?

  • First, the Chinese yuan is now close to its fair value against the dollar, and is actually 3% overvalued. That challenges conventional wisdom about China’s undervalued currency acting as a subsidy for its massive exports.
  • Second, when adjusted for per-capita GDP, the US dollar is by far the most undervalued major currency in the world. Only a handful of other currencies—those in Singapore, Taiwan, and India—are more undervalued than the US dollar.

That confirms other commentators observation that the US dollar is at a 40-year low on a real, broad trade-weighted basis.

The Big Mac Index: What You’d Trade Today
So, if you were running a currency hedge fund, what would the Big Mac Index tell you to trade?

Well, if you use the principal of buying undervalued currencies—and selling the overvalued ones —you’ll come up with several counterintuitive choices.

Among the "big six" of the currencies traded by foreign exchange traders, the Swiss franc (FXF) is the only major currency that is massively overvalued. The euro, the Australian dollar (FXA), and the Canadian dollar (FXC) are also overvalued by at least 20%.

You’d stay away from the Japanese yen (FXY) and the British Pound Sterling (FXB), as these are roughly in line with their PPP values.

Most counter-intuitively, if you used the GDP-adjusted Big Mac Index, you’d buy US dollars (UUP), flying in the face of most "dollar demise" predictions.

Thanks to many new currency ETF offerings, you could also bet on some less mainstream currencies as well.

Looking purely at the original Big Mac Index, you’d buy the Chinese yuan (CYB) (44% undervalued), the Russian ruble (FXR) (34% undervalued), the South African rand (SZR) (29% undervalued), and the Mexican peso (FXM) (33% undervalued).

You’d sell the Swedish krona (FXS) and the Brazilian real (88% and 52% overvalued, respectively).

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