The Big Mac … Purchasing Price Parity … and the Euro

If you were to travel outside of your home country and encountered a McDonald’s, would you pay more or less for a Big Mac?

Well that depends …

You would likely notice a difference though. A major cause of this difference is the value of the local currency relative to your home country’s currency.

For example, a Big Mac in the U.S. will run you about $3.50. If you’re traveling around Germany, you’ll pay in the neighborhood of 3.42 euros for that sandwich. So at current exchange rates, the same sandwich in Germany will cost you $4.82 or 37 percent more than you’d pay in America.

What does this analysis tell you about the value of the euro?

It could tell you that the euro is overvalued. But there are also other factors to consider when comparing the Big Mac across countries: Labor costs, real estate costs, taxes, transportation costs, trade-related costs, the quality perception of the product and other variables that impact doing business in different countries.

Don’t expect to pay the same amount for a Big Mac in China as you would back home.

The bottom line: Running a McDonald’s in Omaha is quite different than running a McDonald’s in, say, Moscow. Nonetheless, it’s a useful quick analysis …

The more academically accepted version of purchasing price parity (PPP) is the measure against a basket of goods and services. These statistics are compiled by the Organization for Economic Co-Operation and Development (OECD).

Both the Big Mac Index and the OECD’s work are broadly accepted tools for assessing the relative under or over valuation of currencies. However, PPP analysis in general is a longer-term tool. It does not incorporate many of the short-term influences that can drive currency values.

Yet it does provide a benchmark equilibrium exchange rate as a reference point, which combined with a healthy dose of assumptions, can be used to normalize the cost of a product across countries.

So What Does PPP Tells Us Right Now About
The Most Overvalued Currencies In the World?

In my chart below, you can see some of the most overvalued currencies according to the Big Mac Index and the OECD’s PPP. The axis on the left shows how overvalued these currencies are relative to the equilibrium exchange rate based on purchasing price parity.

Both measures agree that the Swiss franc is overvalued. The strength of the franc is why the Swiss National Bank stepped in this week, for the second time since March, to halt the rise of its currency against both the euro and the U.S. dollar. Hampered by a strengthening currency, Switzerland’s exports to the rest of Europe, which accounts for more than a quarter of GDP, have been suffering big-time.

At the same time, the Swiss economy is experiencing deflation, and its core banking industry is getting hit by bad loans to eastern and central Europe. What’s more … a global initiative to curtail tax evaders is threatening its bank secrecy model.

Adding to the problems, the Swiss franc has found its traditional appeal lately as a safe haven currency in times of crisis. This has helped send the Swiss franc surging 10 percent against the euro and roughly the same against the dollar since the global financial crisis started to unravel.

And while the euro is undervalued against the Swiss franc, it’s overvalued against almost everything else!

Since reaching all-time lows against the dollar in 2002, the euro nearly doubled in value at its highest point last year. And now it still stands 70 percent higher against the dollar from those 2002 lows. Meanwhile, the fundamentals don’t support the strength. The Eurozone economy is expected to contract by 4.8 percent this year, downgraded from earlier estimates of 4.1 percent.

At the same time, the U.S. economy is expected to have among the smallest contraction of G-7 countries at 2.8 percent. And this week, the OECD upgraded expectations for a global recovery based on expectations that improvement in the U.S. economy would lead a world recovery.

But the OECD’s outlook for Europe was grim …

This week, the ECB pumped over $600 billion into the European banking system to get credit flowing more liberally.

Europe has been slower and less responsive to the crisis than its counterparts and continues to hold its benchmark interest rate above that of the U.S., the UK, Japan, Switzerland and Canada. In fact, officials at the European Central Bank have had strong debates about establishing a 1 percent floor on rates. Alternatively, after assessing the Eurozone economy for itself, the OECD made a direct recommendation that the ECB “exhaust” the room left for rate cuts — and sooner rather than later.

Perhaps the ECB is showing signs of stepping up the fight against its troubling outlook: This week, it made a huge move, injecting more than $600 billion into the European banking system to get credit flowing more liberally.

As For the Undervalued Currencies …

The major Asian export-centric economies dominate those currencies deemed the most undervalued according to purchasing price parity. Among them are the Malaysian ringgit, the Thai baht, the South Korean won, and not surprisingly, the Chinese yuan.

Even after moving from a pegged currency regime to a managed float four years ago — where the Chinese central bank manages the value of the yuan to a basket of currencies — the yuan still remains grossly undervalued.

As I mentioned earlier, the Big Mac Index and the OECD’s PPP aren’t great trading tools. But they do give some additional perspective when combined with fundamental, technical and sentiment analysis.

And considering the challenges facing the Eurozone, these valuations give further reason to believe that the euro will likely come under pressure again before the broadest global recession on record passes.

Regards,

Bryan

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