Originally published by Canstar Research
What is Burgernomics?
The Big Mac Index was invented by The Economist back in 1986, as a way to simplify exchange rates theory for the general public. Also known as Burgernomics, the Big Mac Index judges the value of a country’s currency against how much a Big Mac costs to buy in that country compared to other countries – i.e. the exchange rate.
No doubt the analysts who invented Burgernomics were simply hungry at the time they named their tongue-in-cheek theory – but it’s certainly a useful tool for watching the value of different countries’ currencies. While not intended as a precise tool for currency predictions, it has become a popular global benchmark or standard.
Why the Big Mac?
This ubiquitous burger was chosen as a symbol of ‘equality to power’ theory, probably because there are very few countries in the world where you actually cannot buy a Big Mac.
The theory behind the Big Mac Index is purchasing power parity (PPP). This is the assumption that over the long-term, exchange rates should adjust so that an identical basket of goods and services (a Big Mac) will cost the same in real terms between any two countries. If the Big Mac doesn’t cost the same in two different countries, then it is likely that one country’s currency is under/over-valued.
Here’s an example:
Let’s say that the average price of a Big Mac in the USA is $5.04, and in China it’s USD$2.79 at the market exchange rate. The Big Mac index would therefore suggest that the yuan (China’s currency) is under-valued by 45%.
What does undervalued or overvalued currency mean?
It means that either you require a large amount of a currency in order to make small transactions (undervalued currency), or that you can use small amounts of the currency to make very large transactions (overvalued currency).
This can help to inform your investment decisions, particularly if you’re interested in foreign investments. If a country you want to invest in has an undervalued currency, for each dollar you exchange into the local currency, you may receive more than you ‘should’, based on the differences in PPP.
For example, based on the Big Mac index, one-dollar US should convert to 3.72 Chinese yuan. However, the actual exchange rate in October 2018 is USD$1 equates to CNY6.62. This makes Chinese goods effectively cheaper to buy in the US, and American-made goods more expensive to buy in China.
In turn, you could expect that a Chinese manufacturer will therefore outperform a comparable American one. This is because consumers will be more likely to buy the cheaper products over the dearer ones.
Another thing you may want to be aware of is that the Big Mac index may help you to understand the likely long-term direction that a currency might take. Due to the interconnected nature of global commerce, differences in purchasing power parity tends to smooth out over time. If the Big Mac index shows that a particular currency is undervalued, you can expect that over the long-term exchange rates will adjust so that the PPP is about equal.
This also means that if you invest in a company with an undervalued currency, as the exchange rate corrects, your investment gains should, in theory, be magnified. If you make an investment in a currency that is undervalued by 20% and hold onto it until the PPP valuation has corrected, then your investment should grow by 20%.
Watch out when investing in overvalued currencies though, as corrections to these may to diminish your returns!
How is the Australian dollar going on the Big Mac Index?
Based on The Economist’s raw data calculations for the 2018 Big Mac Index, the Australian Big Mac is at $6.05 AUD, which compared to $5.51 USD is under-valued by approximately 18.1%. Although, when adjusted for the relationship between prices and GDP per person, the Big Mac index suggests that the AUD has been undervalued since 2013 and that the AUD may be shakily rising again, towards our correct long-term exchange rate of parity.
So, is our exchange rate likely to head north again anytime soon? It’s perhaps something to discuss over a hearty lunch.