Exchange Rates: a Big Mac Challenge

Here at Headwater Investment Consulting, we are avid readers of the Economist. One of the articles we look forward to every year is called the Big Mac Index. This is the Economist’s “light-hearted guide to exchange rates.” First published in 1986, it is a measure to see if currencies are over or undervalued versus their exchange rate.

The Big Mac Index is based on an economic theory called purchasing power parity (PPP). PPP claims that with free-floating exchange rates, an identical basket of goods should cost the same across countries. Short term fluctuations might happen, but in general, the discount of currency should make the same products cost the same in every country. The Economist, instead of looking at a basket of goods, takes one thing: A Big Mac. It is a consistent recipe and is available in almost every country around the globe.

The index compares the price of an average Big Mac in each country and uses their relative prices to calculate a “big mac exchange rate.” Then they look at the actual exchange rate to determine the accuracy of the current exchange rate. This gives us an idea of where currencies are headed in the future. From the economist:

“An analysis of data going back to 1986 shows that currencies deemed undervalued by the Big Mac index tend to strengthen, on average, in the subsequent ten years (and vice versa). Something for investors to chew on.”

They also produce a GDP-Adjusted index to show the variance taking into account the relative poverty of different countries. It argues that goods will be cheaper in poorer countries versus richer countries.

This year the Big Mac Index shows that most global currencies are undervalued against the US dollar. Thus, the US dollar is overvalued. This is especially true in emerging markets. According to the BMI, the Russian ruble (₽) is 70% undervalued. A Big Mac in Russia costs 110.17 rubles and in the US a Big Mac costs $5.58, which indicates a BMI exchange rate of 19.74 while the actual exchange rate is 66.69. That means a Big Mac in Russia costs only $1.66. Even when adjusted for GDP, the Russian ruble is 50% undervalued according to this index.

What does this all mean? Well, actually not a lot. It isn’t a great predictor of anything short term, but in the long term, it shows that the dollar will probably fall in the next few years. There has been a lot of global instability recently. Europe is grappling with the flaws of the EU and the Brexit debacle. Japan is still struggling with a huge demographic problem. Emerging markets are held down by slowing global economies and low commodity prices, and China is slowly and painfully clawing its way to be a modern economy away from its roles as the world’s manufacturer. With all of the uncertainty, it’s no surprise that the US dollar is strong. Governments and investors want to keep their money safe. The safest, biggest economy in the world right now? The United States. We might see some of the global problems start to resolve themselves, and the other currencies might rise in relation to the dollar. The other take away? It might be a good time to plan that trip to Russia you’ve always wanted to take.

Click here to access the Economist’s interactive Big Mac Index chart.