If you are an average American, you probably don’t give much thought to currencies.
Yet currencies have a bigger impact on your life than you think. China’s undervalued currency — the yuan — is the reason Chinese goods are so cheap at WalMart — and why so many American companies shipped jobs to Asia over the past decade.
One of the best ways to get your head around the relative currency valuations — and to make money from them — is to look at what the same good costs in Chicago, London, Tokyo and Beijing.
Britain’s Economist magazine has been doing this regularly since 1986 with its now-famous Big Mac Index — a tongue-in-cheek but surprisingly useful way of measuring purchasing power parity (PPP) — that is, the relative over and undervaluation of the world’s currencies compared to the U.S. dollar. The magazine just published the latest version last week.
For an indicator that was as much a product of English humor as it was serious economic design, it’s surprising how seriously some academics and governments take the Big Mac Index. It is now included in several economic textbooks and is the subject of at least 20 academic studies.
According to the theory of purchasing power parity, a dollar should buy the same amount of the same good across all countries.
By comparing the cost of Big Macs — an identical item sold 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.
Not that the Big Mac index is perfect. In Argentina, home to one of the kookiest economic policies on the planet, McDonald’s doesn’t really sell the Big Mac anymore because the government decided it didn’t want to be included in the Economist surveys and regulated the hamburger’s price. And the price of the “Big Mac” in India — the cheapest in the world — is problematic because in India Big Macs are made of chicken. Hindus don’t eat beef.
Global Currencies: The Current State of Play
One thing is clear from the recent survey. The relative value of currencies moved quite a bit during the past six months. Bond King Bill Gross of PIMCO recently noted that he expects countries to enter competitive devaluations — “currency wars” — reminiscent of the 1930s. Back then, economies devalued their currencies trying to give exporters — and by extension their economies — a much-needed shot in the arm.
Certainly, that seems to be the strategy of the new Japanese government. It has forced the devaluation of the Japanese yen by about 14% just over the last three months.
Another big change is in the British pound. With the U.K. economy flirting with a potential “triple-dip” recession, the Big Mac Index had the United Kingdom pegged as one of the most expensive places on the planet for much of the past decade. Yet in the current survey, a Big Mac actually costs less in the United Kingdom — $4.25 — than it does in the United States, where a Big Mac sells for $4.37.
The euro has been on a roller coaster. Four years ago, the euro was overvalued by a massive 50%, compared to the U.S. dollar. At the height of the European crisis last summer, the European currency moved close to purchasing power parity. As the European crisis has receded, it has gone to being 12% overvalued.
So what are the world’s most overvalued currencies? Well, it’s a diverse bunch.
As a group, the Scandinavian currencies have always been the most overvalued ones in the world. A Big Mac in Oslo today is only 79% more expensive than in the United States. The Swiss franc is still 63% overvalued against the dollar.
Brazil’s currency — the real — is next in line. Two years ago, the Brazilian real was 52% overvalued on the Big Mac Index. In July 2012, the real was overvalued by just 17%. Today, the real is back up and is 29% overvalued compared to the U.S. dollar.
A Canadian Big Mac costs $5.39. That price makes the Canadian dollar 24% overvalued. That may be the biggest recent swing in global currency markets. As recently as July 2012, the Canadian dollar was 10% undervalued.
The Chinese yuan remains remarkably stable, still trading 42% below its PPP rate, acting as a massive subsidy to Chinese exports. The Mexican peso is also 33% undervalued — a drop from 21% undervalued in July. This is part of the reason that so many U.S. and global manufacturers are “re-shoring” to Mexico, given lower transportation costs.
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 principle of buying undervalued currencies — and selling the overvalued ones — here is what you’d come up with.
Among the “big six” currencies traded by foreign exchange traders, the Swiss franc (FXF) and the Canadian dollar (FXC) are the only major currencies that are massively overvalued. So, you’d sell those. The British pound sterling (FXB) and the euro (FXE) are roughly in line with their PPP values and offer little opportunity. The Japanese yen (FXY) is now undervalued by 19%. But with the Japanese Central Bank committed to devaluing the yen further, it is tough to make a case for going long on the yen.
Thanks to many new currency exchange-traded fund (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) (42% undervalued), the Russian ruble (FXR) (44% undervalued), the South African rand (SZR) (54% undervalued) and the Mexican peso (FXM) (33% undervalued).
Nicholas Vardy, CFA
Editor, The Global Guru