As there is more talk of optimism returning to the global
economy, a debate continues about how the currency market will
react to economic growth. Is the USD going to continue weaker? Has
the GBP topped out? Is the dollar against the yen going to trade
near to trade at new lows this year? All very good questions and
because no one has a crystal ball, foreign exchange professionals
normally base their best guesses on factors that drive currency
fluctuations, such as supply and demand, interest rates, risk
aversion, gross domestic production and other economic data and
trends. Some of my colleagues may even discuss a myriad of
technical tools for predicting currency movements, including trend
lines, Fibonacci levels and Bollinger Bands.
This week, I thought it might be more interesting to revisit
another economic principle that is rarely discussed in the real
world of foreign exchange. In most macroeconomic text books, you'll
most likely come across the purchasing power parity (PPP) theory
and the law of one price. In its simplest terms, economists refer
to PPP in an attempt to describe how, over a long period of time,
foreign exchange rates will adjust so the price of a basket of
goods in one country will equal the same price in another country.
This one price theory relies on certain assumptions like similar
costs and availability of transportation, the inherent
"tradability" of the good or service and the quality of a product
in one country cannot be substantially different from the same
product in different countries.
Let's look at a simple hypothetical example. If you were an
American visiting a pub in a foreign country and after a few
calculations on your iPhone currency converter application, you
realized you just paid equivalent of $25 for a pint of beer, you
could only conclude one of three things: it's a scam, the beer is
really good, or the currency you are using is extremely overvalued.
If it is a currency issue, the PPP theory might conclude that over
a period of time the currency is expected to fall against the
USD.
The Economist magazine has been publishing its own version
of a PPP theory since 1986. It is called the Big Mac index. The Big
Mac was chosen because it is based on a well-known product and its
prices are easily tracked in over 120 countries. The production of
this "basket of goods" includes a wide range of costs, such as
various commodities, labor, transportation, advertising and real
estate. Since the McDonald's Big Mac is essentially a "standardized
basket of goods and services," in theory the foreign exchange rates
should make the Big Mac cost the same in Canada, Chile, Thailand,
or China as it does in the United States.
If not, the theory would indicate a "valuation discrepancy." So,
when we are comparing actual exchange rates with PPP, we get an
indication of which currencies are under or overvalued. Example: If
a Big Mac costs 12.5 CNY in Beijing and cost nearly $3.60 in San
Jose, the PPP theory, based on this basket of goods, concludes the
exchange rate should be 3.47 CNY to the USD (12.5CNY/3.60 USD). The
present exchange rate is around 6.8 CNY to the USD. Thus, the CNY
is 52 percent undervalued against the USD. On the other hand, using
the same theory, Norwegian krone is 95 percent over valued. The
British pound, Columbian peso and New Zealand dollar appear closer
to equilibrium. (See chart below for a more complete list)
Source: The Economist, Bloomberg
As you can imagine, many find the Big Mac index hard to digest.
The critics are quick to point out the Big Mac is neither a
tradable commodity nor a product that can be easily shipped and
still maintain its "quality." Additionally, local prices can also
be distorted by taxes, property rents, trade barriers and the
demand for hamburgers, which may be different among various
cultures. It is fair to say a Big Mac in a typical family in India
probably does not place the same value as a McDonald's burger in my
house. These are all valid arguments.
Some long-term academic studies have suggested by using the Big
Mac index and placing long-term bet on the most undervalued and
undervalued currencies each year could actually be a profitable.
However, the reality is that implementing the Big Mac analysis, or
any PPP theory, as forecasting model may not fly at the next board
meeting. And its use as an actual investment strategy should not
include much leverage, or for that matter, even real money.
Remember, "burgernomics" was created to provide a fun and informal
insight into the world of macroeconomics. The theory was never
intended to be an exact, scientific predictor of currency
movements, but rather, an attempt to make a theoretical exchange
rate theory a bit more palatable.