IF you have been following the global economy for the past 20 years or so, then you have probably heard of The Big Mac Index. It was first presented in 1986 as a semi-humorous way to measure purchasing power parity between countries.
Purchasing power parity has been characterized as “macroeconomic analysis metric to compare economic productivity and standards of living between countries.” Also, it is supposed to be a way to evaluate if the currency of a particular country is “expensive” or “cheap” in relation to another nation.
The index starts with the premise that all Big Macs are created equal. Then the assumption is made that all Big Macs should have the same price, and that the difference in price is caused by imbalances in the currency exchange rate.
The 2019 Big Mac index was released a few months ago. Based on the dollar exchange rate, a Big Mac costs $4.67 (R17.5) in Brazil, while it costs only $3.18 (S10.5) across the border in Peru. In New York, the iconic sandwich is priced at $5.74. Therefore, a Big Mac is cheaper in Brazil and Peru than in the US, and cheaper in Peru than in Brazil.
The conclusion is that—at the time of the survey—the Brazilian real is undervalued by 20 percent to the US dollar, and the Peruvian sol is 44 percent “undervalued.” Based on a Philippine peso/US dollar exchange rate of 51.32, the peso is undervalued by 52 percent.
In truth, the conclusion is all nonsense.
Based on the index, the only currency in the world that is “overvalued”—where a Big Mac costs more than in the US—is Switzerland by 14 percent. At the other end of the scale is Malaysia, where the ringgit is 63 percent undervalued, and Russia, where its currency is 64 percent undervalued.
The index assumes that the production and distribution costs of a Big Mac are identical across the globe. Economists have a great problem plugging real-world variables into their theories. Russia, for example, has high government subsidies for all energy sources. The European Union nations spend almost $500 billion a year on subsidizing prices for agricultural production. Based on The Big Mac index, the euro is 20 percent undervalued against the US dollar.
However, the index has better validity when GDP-adjusted. You expect a Big Mac to be cheaper in “poor” countries where labor costs are lower. The relationship between prices and GDP per person is a better guide to the current fair value of a currency.
If per-capita GDP is lower, then you would expect the sandwich to have lower retail price. Further, you can then “predict” what that price should be. For example, if a Big Mac costs about 20 percent less in Brazil than in the US at market exchange rates, based on differences in GDP per person, a Big Mac should instead cost 39 percent less.
This suggests that the Brazilian real is 32 percent overvalued not undervalued on the actual price based on the currency exchange rate. Using this method, the Peruvian sol is 6 percent undervalued not 44 percent.
For the Philippines, based on per- capita GDP in relation to the Big Mac price, the peso is about 15 percent undervalued. For a Philippine Big Mac to “trade” at parity with McDonald’s in New York City, the peso/dollar exchange rate should be about 43.50.
The last time the peso was at that level was in January 2013 when crude oil hit $100 per barrel and the US dollar index was 18 percent higher. Conclusion: the peso and the Philippine Big Mac are priced correctly.
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