The Big Mac index and currency valuations

by Nicholas Vardy, editor The Global Stock Investor.

It’s the 24th year running that the Economist magazine has published its famed Big Mac Index.

This index is a tongue-and-cheek way of measuring the purchasing power parity (PPP) — that is, the relative overvaluation and undervaluation of the world’s currencies. Here's what the Big Mac says about global 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 they do abroad.

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

Only a handful of currencies are within 5% of their Big Mac PPP value — among them are places as far flung as Uruguay, Turkey, Peru, New Zealand, Japan, Israel, Australia and Costa Rica.

At the same time, thanks to the depreciation of the British pound and the euro, and the appreciation of the 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, that overvaluation figure is down to 16% today.

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 Philip-pines 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, 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 turned Brazil into 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.

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 significantly off kilter with their purchasing power parities.

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 WisdomTree Dreyfus Chinese Yuan (CYB) (48% undervalued), the CurrencyShares Russian ruble (XRU), which is 38% undervalued, the WisdomTree South African rand (SZR), which is 34% undervalued, and the CurrencyShares Mexican peso (FXM), which is 33% undervalued.

You’d sell the CurrencyShares Swiss franc (FXF), the CurrencyShares Swedish krona (FXS) and the WisdomTree Brazilian real (BZF). These three currencies are 66%, 78% and 31% overvalued, respectively.

Learn more about this financial newsletter at Nicholas Vardy's Global Stock Investor.