The "Big Mac" Index for 2008

The "Big Mac" Index for 2008

Fellow Investor,

It's the 23rd year running that the Economist has published its famed Big Mac Index -- a tongue and cheek way of measuring the 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 that is 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 America as it does abroad. Compare the Big Mac PPP to the market exchange rates, and voilà!... you see which currencies are under or overvalued.

The Big Mac Index: The Currency Lineup Today

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. But for all of its weaknesses, the Big Mac Index has caught on among investors as a shorthanded way of looking at PPP across the world's economies. The table below -- reproduced from the Economist -- shows by how much, in Big Mac PPP terms, selected currencies were over or undervalued at the end of January.

Despite a turbulent past year for stocks, bonds and currencies, according to the Big Mac Index, many currencies are even further away from their real value than they were a year ago. In fact, only a handful of currencies are close to their Big Mac PPP. Broadly speaking, Latin American currencies -- with the notable exception of Brazil -- are the most in line with their Big Mac Index PPP values.

Currencies are most overvalued in Europe, but are very cheap in Asia. The euro is overvalued by a massive 50% -- up from 19% a year ago. While the British pound has remained broadly steady, the Swiss franc has soared from 57% to 79% overvalued against the dollar. The Scandinavian currencies are by far the most overvalued currencies. A Big Mac in Oslo, Norway, is the most expensive in the world today, and will cost you a whopping 121% more than in the United States. Neighbors Denmark and Sweden have gotten more expensive during the past year, with their currencies now 67% and 79% overvalued, respectively.

Asia is the only relative bargain for those who earn their money in U.S. dollars. The Japanese yen, undervalued by 27%, is essentially unchanged from last year. The Singapore dollar has gained some but is undervalued by 18% and the South Korean won is undervalued by 12%. The Big Mac index also makes clear the reasons for the Asian export boom. Hong Kong, Malaysia, the Philippines and several other Asian currencies are 45-52% undervalued -- even cheaper than they were a year ago. The currencies of less well-off Asian countries, such as Indonesia and Thailand, are equally cheap.

The most undervalued currency in the world is the Chinese yuan, trading 49% below its PPP rate - compared to 56% last year. That supports the argument that China's cheap currency effectively acts as a massive subsidy to Chinese exports. But there's not much slack in the system for the Chinese. Even the relatively slight appreciation of the yuan during the last 24 months has squeezed Chinese exporters that already operate on razor-thin margins, and the rate of export growth from China is slowing.

What about the other red-hot BRIC economies besides China? The Big Mac Index omits India altogether. (Because Hindus do not eat beef, India's version of the Big Mac -- the Maharaja Mac -- is made of chicken.) Visitors to Moscow -- a more expensive city than London -- will be surprised to learn that Big Macs still are 29% cheaper there than in Chicago. The appreciation of the Brazilian real during the past few years has made it 33% overvalued and made Brazil one of the most expensive places on the planet for a Big Mac.

Most remarkable is how quickly Eastern Europe's cost advantages compared with Western Europe have eroded during the last three years. Ten years ago, Eastern Europe's cost advantages were less than half the cost of Western Europe. Today, a Big Mac costs more in Budapest, Hungary, than it does in London. Only Poland and Slovakia remain roughly in line with Western Europe.

The Big Mac Index: What to Trade Today

Opinions on the future of the dollar couldn't be more varied. Cassandras continue to forecast its utter demise and are using any short-term rallies to exit the currency. The IMF thinks that the big drop in the greenback's value since 2002 has left it "close to its medium-term equilibrium level." Morgan Stanley' Stephen Roach believes that the dollar is seriously undervalued and expects the dollar to rally as the rest of the global economy also weakens.

So if you were running a currency hedge fund, what would the Big Mac Index tell you to trade? Among the big six of the currencies traded by foreign exchange traders, the yen, the euro, and the Swiss franc are the major currencies most out of kilter with their purchasing power parities. Looking purely at the Big Mac Index, you'd buy the Japanese yen (FXY), (27% undervalued), the Australian dollar (FXA), (6% undervalued), and the Mexican peso (FXM), (12% undervalued). You'd sell the Swiss franc (FXF), the Swedish krona (FXS), the euro (FXE), and the British pound (FXB), (78%, 79%, 50% and 28% overvalued, respectively.)

That advice seems simple -- but in all likelihood it would be wrong. These are the same trades you'd have put on a year ago -- and you would have lost money in the process. While the Australian dollar and Mexican peso appreciated somewhat during the last year, your short positions in the soaring European currencies -- Swiss franc, the Swedish krona, the euro and the pound -- would leave you nursing some very big losses. As compelling as the Big Mac Index may seem in the long term, currency traders play by their own set of rules.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru