Originally published by Canstar Research
Where is the Australian dollar heading? It’s a question that employs the minds of many economists, fund managers and currency analysts around the world. A more light-hearted answer, though, may lie in a humble burger.
The Big Mac Index was invented by The Economist back in 1986, as a way to simplify exchange rate 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.
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.
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 undervalued by 45%.
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 3.75 Chinese yuan. However, the actual exchange rate in May 2019 is USD$1 equates to CNY6.90. 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!
Based on The Economist’s raw data calculations for the January 2019 Big Mac Index, the Australian Big Mac is at AU$6.10, which compared to US$5.58 is undervalued by approximately 22%. 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.
This advice is general and has not taken into account your objectives, financial situation, or needs. It is not personal advice. Consider whether this advice is right for you, having regard to your own objectives, financial situation and needs. You may need financial advice from a suitably qualified adviser. For more information, read Canstar’s Financial Services and Credit Guide (FSCG) and our detailed disclosure. Canstar may receive a fee for referring you to a product provider – for further information, see how we get paid. Payment of fees for ads does not influence our Star Ratings or Awards.
Canstar is a comparison website, not a product issuer, so it’s important to check any product information directly with the provider. Consider the Product Disclosure Statement (PDS), Target Market Determination (TMD) and other applicable product documentation before making a decision to purchase, acquire, invest in or apply for a financial or credit product. Contact the product issuer directly for a copy of the PDS, TMD and other documentation.
Canstar is an information provider and in giving you product information Canstar is not making any suggestion or recommendation about a particular credit product or loan. If you decide to apply for a credit product or loan, you will deal directly with a credit provider, and not with Canstar. Rates and product information should be confirmed with the relevant credit provider. For more information, read the credit provider’s key facts sheet and other applicable loan documentation for that product. Read the Comparison Rate Warning.
All information about performance returns is historical. Past performance should not be relied upon as an indicator of future performance; unit prices and the value of your investment may fall or rise.
Canstar is an information provider and in giving you product information Canstar is not making any suggestion or recommendation about a particular product. The information has been prepared without taking into account your individual investment objectives, financial circumstances or needs. Before you decide whether or not to acquire a particular financial product you should assess whether it is appropriate for you in the light of your own personal circumstances, having regard to your own objectives, financial situation and needs. You may wish to obtain financial advice from a suitably qualified adviser before making any decision to acquire a financial product. Please refer to the product disclosure statement (PDS) and Canstar’s Financial Services and Credit Guide (FSCG) for more information, and read our detailed disclosure, important notes and liability disclaimer.
All information about performance returns is historical. Past performance should not be relied upon as an indicator of future performance; unit prices and the value of your investment may fall or rise.
Canstar may earn a fee for referrals from its website tables, and from Sponsorship or Promotion of certain products. Fees payable by product providers for referrals and Sponsorship or Promotion may vary between providers, website position, and revenue model. Sponsorship or Promotion fees may be higher than referral fees. Sponsored or Promotion products are clearly disclosed as such on website pages. They may appear in a number of areas of the website such as in comparison tables, on hub pages and in articles. Sponsored or Promotion products may be displayed in a fixed position in a table, regardless of the product's rating, price or other attributes. The table position of a Sponsored or Promoted product does not indicate any ranking or rating by Canstar. For more information please see How We Get Paid.
Any advice provided on this website is general and has not taken into account your objectives, financial situation or needs. Consider whether this advice is right for you. Consider the Product Disclosure Statement and Target Market Determination before making a purchase decision. Canstar provides an information service. It is not a credit provider, and in giving you information about credit products Canstar is not making any suggestion or recommendation to you about a particular credit product. Research provided by Canstar Research AFSL and Australian Credit Licence No. 437917. You must not reproduce, transmit, disseminate, sell, or publish information on this website without prior written permission from Canstar.