The Big Mac Index - Is your country's currency undervalued?

Recently, I read about an index published by The Economist - the Big Mac Index.

So what is it? How can we use it? Let's dive deep in!

The easiest way of explaining this index is to first break it down into sections:

1. What does it measure?

2. The concept behind the Big Mac Index

3. Explanation of the index and putting it into practice

---

1. What does it measure?

The Big Mac index is set out to measure purchasing-power-parity.

Purchasing-power-parity is a term that wraps up the concept that theoretically, if Country A has the same exchange rate as Country B, (Country A $1 = Country B $1) then the prices of things in Country A should be the same as Country B, the people in Country A and Country B can buy almost everything under the same price tag-everything is good and happy-except, this is only theoretically speaking.

Reality hits home when factors such as political stability and foreign investor confidence would cause currencies to be overvalued or undervalued. Meaning, even if Country A has equal exchange rates as country B, the people in Country A may be able to consume or buy less than the people in Country B, so the power of purchases varies-hence, the Purchasing-power-parity. Simple, yes?

(As of now, this is the definition you'll need to be able to understand the article, but I would suggest that you read this article explaining the nuances of the PPP to learn more about it in the future.

---

2. The concept behind the Big Mac Index

The Big Mac Index is an illustrative way of showing the purchasing-power-parity.

How so?

Generally speaking, most countries have McDonalds' dominating their fast-food market. In every McDonalds' restaurant, I can almost guarantee that you'll find the good-ol' Big Mac on its menu. So the concept that the Big Mac is something so easily accessible to a vast majority of geographies is established.

---

3. Putting into practice and the explanation

Next, let's look at how 'the fair value of a currency should reflect its power to buy goods and services', as quoted from The Economist.

For the sake of accuracy, I'm using prices given in the article above, and embedding it in my example.

Skip to * to get straight into the numbers and skip the heavy narrating

You're a very busy business person, currently in Hong Kong for a very important meeting. On this one fine day, in between your Board Meetings and Credit Committees, you fancied yourself a burger. So, you walked into the nearest fast-food chain you could find. Darn it, you can only spot a heavily plastered, red-white-yellow striped, inflated balloon-man waving your way. So, what choice do you have other than walking into the restaurant it ambassadors? It was just that persuasive.

Photo Credits: mcdonalds.fandom.com

Now, in that shop you choose off the menu what you are most comfortable with - the trusty Big Mac, filled with that good ol' hand-picked lettuce for that refreshing crunch, that double free-range beef patty, triple toasted bun with sesame seed-

you get the idea.

You buy the burger for HK$20.50. Happy and jolly, you're out the door, rushing for the credit committee next up in your schedule.

Fast forward, a few weeks later, you've arrived in the United States of America, for a very important IPO listing. You feel passionate about this listing, you feel exhilarated, you feel enthusiastic-and all this enthusiasm is really fueling your hunger.

Understanding that being hangry (hungry + angry) was not the way to go if you want to impress your clients, you quickly devised a scheme so carefully curated, so complex, so comprehensive, that even Bill Gates would give a standing ovation to it- you decide to eat.

You go to your nearest McDonalds'. After all, the heavily plastered, red-white-yellow striped, inflated balloon-man waving your way was too convincing, how could you not?

You, then again, as ever predictably, settled with the good ol' Big Mac. Only, this time, it costs USD $5.71 instead of the HK $20.50 that you paid when you were in Hong Kong.

*

Big Mac Costs

HK - HKD $20.50

US - USD $5.71

Hold up--something in your brain snapped. Something wasn't adding up:

The exchange rate from USD to HKD is USD $1 = HKD $7.75 (as taken from Morningstar in late November 2020)

This means for every dollar you spend in USD, you spend its value multiplied by $7.75 in HKD. So if you spent USD $5.71, in HK, you would spend USD $ 5.71 x 7.75 = HKD $44.25

BUT

Following the costs from your very important stomach-filling 'investment', you realised that using the same concept USD 5.71 : HKD 20.50 and simplifying the ratio would give USD $1 : HKD $3.59

What absurdity is this?

And this, my friend, is where the concept of undervalued or overvalued currencies come in. Strap up, it's a long ride.

Now, the actual exchange rate is USD $1 : HKD $7.75

Following the latter ratio USD $1 : HKD $3.59 from your actual purchases, you see that in reality, for every USD you spend, you would only have to spend HKD $3.59.

This is the exchange rate that equalises your Big Mac buying power.

This exchange rate is much stronger than the actual exchange rate.

And vice versa

The actual exchange rate is much weaker than the real exchange rate you used in real life to get that glissful Big Mac.

What does this mean?

This means that the Hong Kong currency is undervalued vs USD.

Because, in real day-to-day consumption, you would only need HKD $3.59 to a USD. You would only need HKD $3.59 : USD $1 for something of the same value.

But, when investing, we don't use this number, we use the actual exchange rate USD $1 : HKD $7.75. Which means you would need HKD $7.75 : USD $1. That's roughly HKD $4.16 more per USD, which means, HKD$4.16 per USD undervalued.

This goes to show how the USD is overvalued vs HKD,

and the HKD undervalued to USD.

Now, that's the end to it!

Or is it?

Obviously, I've only shared with you what the Big Mac Index is about, its concept, and how you could calculate it. But there are many different ways we can use the index to get economic insight on the dynamics between currencies.

As a starter, I would suggest you go to your local McDonalds' (or to its website, which is logistically more rational) and get its prices for its Big Mac down. Next, go to the McDonalds' website of a country you would like to compare your local currency to, and implement the same concept I have shown above!

At the end of the day, the Big Mac concept does have its flaws, as such with other indexes. E.g. it has not taken into account the raw material cost difference between each country, the logistic cost etc. which does play a part in the price of the Big Mac in its respective country. Nevertheless, it still serves its purpose when measuring which currency is undervalued-and which are overvalued.

Go have fun with the Big Mac Index! If you have any questions regarding it, or feel stuck in your understanding, do not hesitate to leave a comment below!