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 America as they do 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 July.
Only a handful of currencies are within 5% of their Big Mac PPP value -- among them places as far-flung as Uruguay, Turkey, Peru, New Zealand, Japan, Israel, Australia and Costa Rica. At the same time, thanks to depreciating British pound and the euro and the appreciating Japanese yen, the PPP values among the most-traded currencies in the world are about as in line as they have been in recent memory.
As usually has been the case, the most overvalued currencies are in Western Europe. The most undervalued ones are in both Asia and Eastern Europe. Two years ago, the euro was overvalued by a massive 50% compared to the U.S. dollar. After a massive correction in the euro this year, today that figure is down to 16%. A similar fate has befallen the British pound, which is undervalued for the first time in recent memory.
Other European currencies remain strong. The Swiss franc is overvalued by 68% against the dollar. As a group, the Scandinavian currencies are by far the most overvalued currencies in the world. A Big Mac in Oslo, Norway, will cost you twice as much as in the United States, with its currency overvalued by 93%. Sweden has retained its reputation as being expensive, with its currency 76% overvalued. Denmark is Scandinavia's bargain. Its currency is only 31% overvalued -- a substantial drop from last year, as it is de facto linked to the euro.
Asia is the region where those who earn their money in U.S. dollars find a bargain when buying a Big Mac. Although the Japanese yen has risen substantially to hit fair value, the Singapore dollar remains undervalued by 18% and the South Korean won by 24%. The Big Mac Index also makes clear the reasons for the Asian export boom. Hong Kong, Malaysia, the Philippines and Thailand remain about 40% undervalued -- though they are more expensive than they were a year ago. The currencies of less well-off Asian countries, such as Indonesia and Thailand, are equally cheap.
The Chinese yuan remains 48% below its PPP rate -- the recent “flexibility” of the Chinese government’s approach to the yuan notwithstanding. A Big Mac costs $1.95 in China at current exchange rates versus $3.73 at your local mall in Ohio. No surprise that China's cheap currency acts as a massive subsidy to Chinese exports.
What about the other 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 -- one of the most expensive cities in the world -- will be surprised to learn that Big Macs still are 38% cheaper there than in Chicago. The appreciation of the Brazilian real during the past few years has made it 31% overvalued and made Brazil one of the most expensive places on the planet to buy a Big Mac.
Most remarkable is how quickly Eastern Europe's cost advantages shifted over the past couple of years. Two years ago, a Big Mac cost more in Budapest, Hungary, than it did in London. Today, that position has reversed. In fact, the Baltic countries (Latvia, Lithuania and Estonia) and Poland are almost as cheap as Asia -- though Hungary and the Czech Republic remain more in line with Western Europe.
Latin America is a mixed bag. This year, Argentina claimed the title of most undervalued currency in the world (from China), and Mexico is very cheap. At the same time, as noted, booming Brazil has one of the most overvalued currencies in the world.
The Big Mac Index: What to Trade
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 Swiss franc is one of the only major currencies much off kilter with its purchasing power parity. But the explosion of new currency ETF offerings affords you an opportunity to bet on some less mainstream currencies as well.
Looking purely at the Big Mac Index, you'd buy the Chinese yuan (NYSEARCA:CYB) (48% undervalued), the Russian ruble (XRU) (38% undervalued), the South African rand (NYSE:SZR) (34% undervalued), and the Mexican peso (NYSEARCA:FXM) (33% undervalued). You'd sell the Swiss franc (NYSEARCA:FXF), the Swedish krona (NYSEARCA:FXS) and the Brazilian real (NYSEARCA:BZF) (66%, 78% and 31% overvalued, respectively).