The theory of purchasing power parity says that a dollar should buy the same amount in all countries. Thus, 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 looking at a McDonald's Big Mac -- a good that is produced in about 120 countries -- the Economist's tongue-in-cheek index illustrates how market exchange rates can result in identical goods having different prices in different countries. By comparing the cost of Big Macs across countries, the Big Mac Index calculates the Big Mac PPP -- the exchange rate that would mean hamburgers cost the same in the U.S. as abroad. Compare the Big Mac PPP to the market exchange rates, and voilà!... you see which currencies are under or over valued.
The Big Mac Index: An Imperfect Measure
The Big Mac Index does have its shortcomings. A Big Mac's price reflects more than just the cost of bread and meat and vegetables. It also reflects non-tradable elements -- such as rent and labor. For that reason, the Big Mac Index probably is best when comparing countries at roughly the same stage of development. In any case, there is no theoretical reason why non-tradable goods and services should be equal in different countries. That explains why PPPs are different from market exchange rates over time.
Furthermore, eating a Big Mac means different things in different countries. Indians eat fewer Big Macs than Americans. In some countries, eating at McDonald's is a relative luxury. Whereas low-income Americans may eat at McDonald's a few times a week, low-income Malaysians rarely eat Big Macs. Finally, local taxes, levels of competition, and import duties on Big Mac components may not be representative of the country's economy as a whole.
The Big Mac Index: The Currency Line Up Today
For all its weaknesses, the Big Mac Index has caught on even among economists 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.
The Scandinavian currencies, as a group, are by far the most overvalued currencies, with the Icelandic krona taking the crown as the #1 overvalued currency in the world. A Big Mac in Reykjavik will cost you a whopping 131% more than in the U.S. The Norwegian krone is overvalued by 106%. Neighbors Denmark and Sweden are relative bargains, since their currencies are only 50% and 45% overvalued, respectively.
The most undervalued currency in the world is the Chinese yuan, trading 56% below its PPP rate. That's why Hank Paulson is putting pressure on the Chinese government to revalue its currency. And that's why China's cheap currency effectively is acting as a massive subsidy to Chinese exports. There's not much slack in the system, as far as the Chinese are concerned. Even the slight appreciation of the yuan over the last 18 months has squeezed Chinese exporters that already operate on razor-thin margins.
What about the other red hot BRIC economies, besides China? The Big Mac Index omits India altogether. Russia is almost as undervalued as China, with Big Macs 43% cheaper in Moscow than in Chicago. Brazil -- after a huge appreciation in the value of the Brazilian Real over the past few years -- is just about where it should be.
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 40-50% undervalued.
Most remarkable is the divergence among the new entrants to the European Union. Hungary is by far the most expensive; its cost advantages, compared with Western Europe, have completely eroded over the last three years. The Czech Republic, Poland, and Slovakia are still relatively inexpensive, with the currencies undervalued by 25-35% compared with the U.S. dollar.
The Big Mac Index: What To Trade Today
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 Australian dollar are the major currencies most out of kilter with fundamentals.
Looking purely at the Big Mac Index, you'd buy the Japanese yen (28% undervalued), the Australian dollar (FXA) (17% undervalued), the Mexican peso (FXM) (17% undervalued). You'd sell the Swiss franc (FXF), the Swedish krone (FXS), the euro (FXE) and the pound (FXB), (57%, 43%, 19% and 21% overvalued, respectively.) You could make all these trades today -- except for the Japanese yen. For some curious reason, no one has yet launched a Japanese yen ETF.
Here's the challenge: Had you been short the yen over the last few months, you'd be nursing some big losses. And indeed, it's likely that every trend-following hedge fund on the planet is short the yen -- despite it being fundamentally undervalued. As a resident of London, the world's most expensive city, I'd welcome a 20% drop in the U.K. currency. But with interest rates rising and the U.K. economy firing on all cylinders, that kind of devaluation seems like a distant prospect...