The Big Mac Index or how much is a dollar?
How can you find out whether the currency is undervalued or overvalued? You can assess the Big Mac Index in a certain country.
“Burgernomics” is not an absolute indicator of the currency disparity. But the index has become a global standard; it is included into some textbooks on economics and is a subject of academic studies.
This index was introduced in the Economist journal in 1967. At that time a hamburger cost 47 cents. 20 years later, it was $1.6. Currently, a Big Mac costs about $4.30. Therefore, dollar has become ten times cheaper during the last fifty years. Of course, it doesn’t mean that dollar will be 10 times cheaper in another fifty years. Though, a certain trend is obvious.
Undervaluation and Overvaluation of an exchange rate
Currency volatility has quite a strong influence on the economy, but most people don’t pay any attention to it, as most of the transactions are made in the national currencies. A common person is interested in the exchange rates during traveling abroad, paying for goods, bought abroad or financial transfers abroad.
People can be happy with the strong local currency, as it reduces their costs for imported products and for traveling. But a substantially strong currency may sometimes badly affect the financial sector in the long-term prospect. Industries become profitless, in the market, millions of people become jobless. Common people can be discontent with the weak local currency, as tourism and import become more expensive, but the undervalued currency can yield a lot of benefits to the national economy. The exchange rate of a currency is a central bank’s tool, an important means of the monetary policy. So, either directly or indirectly, a currency undervaluation or overvaluation affects many variables. It will affect the interest rate, the returns of an investment portfolio, prices for goods and services, employment rates.
Let’s study the undervaluation and overvaluation of some currencies on real examples.
In the monthly chart of USD/JPY, it is clear that yen is growing stronger against the US dollar. This trend can well continue because the Big Mac Index indicates yen undervaluation against the US dollar. So, the rates may continue falling down in the coming months. Yen is undervalued to the US dollar by 36.58%, which is rather significant. It can’t but affect Japan’s economy. But Japan may be interested in this imbalance. The Japanese want to sell their products, and so, they artificially undervalue their national currency.
You should also remember that the national currency is strictly regulated in Japan. We have many times witnessed how the Japanese yen grew stronger or fell in price without any reasons. Yen rate is still hard to predict.
As for the New Zealand dollar/US dollar pair, the kiwi is undervalued and can well grow stronger against the US dollar. According to the Big Mac Index, it is 16.37 % undervalued. The kiwi rate strongly depends on the crop yield in New Zealand, on the prices for certain commodities and foodstuffs. So the price may go up. Although, the pair could be trading in the same direction for a long time, both up and down. Visually, you see that the price is moving in the centre of its trading range.
Euro is also undervalued against dollar by 16.37%, so, it can continue rising in price. However, EUR/USD could both rise up to 1.23 and fall down to 1.035. The recent price of $1.23 also suggests that euro is undervalued. Though, Forex is always surprising and unpredictable.
According to the Big Mac index, the Australian dollar is 14.57% undervalued. The AUD is relatively cheap, but it can change soon. It is clear from the chart that the AUD/USD pair is close to its local low. The price chart used to rise up to 1.10 USD for one “Aussie”. Of course, you shouldn’t expect the same soon; the pair’s uptrend is quite likely.
Australian economy and financial sector depend on the gold prices, for example. If the precious metal price drops, Australia’s financial sector suffers. But charts of gold and AUD/USD are not completely the same. In addition to gold, Australia exports a lot of iron ore, coal, food. High prices for these products can support the “Aussie”. And vice versa, the price drop for Australian exports can make the Australian dollar decline in value.
The Canadian dollar is undervalued as well. If you study the table of Big Mac costs, you’ll see that the “loonie” is 12.16% undervalued. USD/CAD was trading at both 1.60 rate and 1:1.
Will the Canadian dollar grow stronger? Nobody can say for sure, but the Big Mac index can well be correct, indicating it. USD can well go down against CAD. It is, of course, about the long run. The pair of the Swiss franc – the Japanese yen is the most demonstrative of the popular currency pairs, featuring the strength of one currency and the weakness of another. Yen is rather weak (-36.58%), and the Swiss franc is the strongest (+27.2%) of all. The most likely, yen will be growing stronger, and franc value will go down. The pair rate can well go down. At least, the Big Mac index suggests it.
The pair of the US dollar - the South African rand is also quite illustrative. Rand is clearly undervalued (57.34%). However, it has been actively rising in the recent times. Rand may grow even stronger, though this currency is hard to predict. According to the monthly chart, one can assume that the current trend will continue.
Of course, you need to pay attention to not only the Big Mac index, but to “how far” a certain price chart has gone.
When the price goes down too deep, it grows more likely to surge sharply. And vice versa, when the price jumps too high, it is likely to drop. Rand, like the “Aussie”, strongly depends on the gold prices. The South Africa still produces a lot of gold. The country’s economy and financial sector strongly depend on the gold prices. In addition to gold, the SAR produces much platinum (the largest global producer), coal, iron ore, cobalt and so on. All of this must be taken into account if you trade this currency pair.
If you trade USD/ZAR you must also know that there can often be social unrest, strikes and attacks on the offices of gold producing companies and other turmoils. If there are problems in the South Africa, the Big Mac index won’t be the basis of trading decisions. If investors withdraw their capitals from the country, factories are shut down, gold mines are blocked, then, the national currency is falling down in value very quickly.
Dollar can also be devaluing fast. It is not the gold standard. However, the gold price is also changing all the time. If the US Fed wants to change the interest rate, this factor will be the primary one in any way. And then, it won’t be that important how much a Big Mac is. The price for a hamburger won’t be that significant. For example, in 2008, dollar dropped down sharply when the interest rate had been reduced to 0%-0.25%.
In addition to Swiss franc, there are also overvalued Norway krone by 11% and Sweden krona 9.79%. These currencies are traditionally overvalued. However, this factor must also be taken into account in trading. Too overvalued currencies can well fall in price, especially against the undervalued ones.
Cheap and expensive Big Mac
Why is this burger so expensive in Switzerland? First of all, because of the expensive labour force. A labourer in Switzerland earns dozens of times more than a worker in Egypt, for example. The Big Mac index can also be affected by such factors as the weather. In Switzerland, it is rather cold during six month of the year, cattle grazing is almost impossible, they have to heat buildings, and so on.
Labour cost is also expensive in Sweden and Finland. Weather conditions are also difficult in these countries. It is not surprising that a burger there is much more expensive than in most other countries.
Much depends on the inflation changes. For example, in Argentina in 2001, when there was a very violent crisis, a Big Mac was cheap because labour force cost very cheap, and the prices for many products dropped sharply, if converted into the free foreign currency.
You can’t estimate the total economic performance of a certain country, based on the Big Mac index alone, though it should be taken into account as well. For example, Thailand and Japan are close to each other, according to the Big Mac index. However, the incomes of the Thai and the Japanese can’t be even compared. Thailand has its advantage in the cheap labour, and Japan benefits from the automation of many processes and the efficient utilization of manpower. For example, to perform a few tasks, there are a few people needed in Thailand. But the same tasks can be completed by a single operator in Japan
Why is the burger rather expensive in Canada? In Canada, in fact, there is produced a lot of crops, cattle, oil and so on. But the weather conditions in the country are very hard. If, for example, in Russia, there are some regions, where tropical plants can be grown, it is completely impossible in Canada. Heating is expensive, especially during extremely cold winters. The Labrador Current strongly “cools” the country, being rather costly for the tax payers and employers.
Anyway, the Big Mac index is of interest to the traders from the Western countries with strong currencies, rather than to those from the underdeveloped countries.
What conclusion should be drawn with regard to the Big Mac index in trading currency pairs? This index can’t be an absolutely accurate indicator or a reference point for action. But still, the Big Mac index can often suggest a proper judgment on whether a certain currency is undervalued or overvalued.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.