Business | Opinion
Channel Sponsor
Vantage View: Valuing Arab currencies using the Big Mac index
- By Dr. Henry Azzam
- Published: 00:00 June 15, 2004
The Big Mac index was devised by The Economist in 1986 as a light-hearted indicator of whether currencies are at their "correct" valuation level. This innovative notion, referred to by the magazine as "Burgernomics", is based on one of the oldest concepts in international economics; the Purchasing Power Parity (PPP), which holds that in the long-run currencies should move towards the exchange rate that equalised the prices of an identical basket of goods and services in each country.
The consumer basket in this case was limited to the Big Mac hamburger claimed by McDonald's to be roughly the same in all the company's outlets worldwide. The Big Mac PPP, calculated by dividing the local currency price of a Big Mac in a certain country by its American price, is the exchange rate that would leave Big Mac prices the same in the US as in other countries. Comparing actual exchange rates with PPPs reveals, albeit simplistically, whether currencies are over or under valued against the dollar. If the current exchange rate of a currency gives a higher value for the Big Mac in the domestic market than in the US, ie it is below the PPP price, then the currency is considered to be overvalued. If it is higher than the PPP price, it is undervalued.
Conversion
The first column of the table shows the local-currency prices of a Big Mac. The second converts these into dollars at the current exchange rate. The average American price of a Big Mac in four American cities is put at $2.90, including taxes. The cheapest Big Mac in the region is in Egypt at $1.62, while the most expensive is in Lebanon at $2.84. By this measure, the Egyptian pound is the most undervalued currency and the Lebanese Lira is least undervalued. The third column calculates Big Mac's Purchasing Power Parity (PPPs). Dividing the Jordanian price of Big Mac by the American price, for instance, gives a dollar PPP of JD 0.64, which is 10 per cent lower than the actual exchange rate of JD 0.71. This implies that the Jordanian dinar is 10 per cent undervalued.
The Big Mac index indicates an overvalued euro to the dollar based on a weighted average of Big Mac prices in the euro area. The European currency is now trading at $1.22 to the euro (0.82 to the dollar), compared to a purchasing power parity of 1.06 euro to the dollar. The index suggests that the euro is now 29 per cent overvalued compared to its PPP (Big Mac in Europe is 29 per centmore expensive than in the US). The euro could well overshoot its PPP because of America's rising current account deficit and with interest rates on the euro higher than those on the dollar. However, the Big Mac index is flashing an overvalued European currency which could bring the euro down back to its purchasing power parity with the dollar of 1.06 by year end.
Undervalued
According to the Big Mac index, the Egyptian pound is significantly undervalued against the dollar by 40 per cent, with a PPP of 3.45 pounds to the dollar compared to the current exchange rate of 6.20 pounds to the dollar.
However, market forces indicate otherwise with a widening balance of payment deficit and excess demand for dollars in the exchange market putting downward pressure on the pound. It is likely that the cost of non-traded inputs, particularly lower labour costs, rents and profit margins in Egypt, may have distorted the price of a Big Mac, thereby biasing the country's PPP downward.
The Big Mac index shows that the Saudi riyal, at an exchange rate of 3.75 to the dollar and the UAE dirham at 3.67 to the dollar are undervalued by 10 per cent and 15 per cent respectively. However, with oil prices exceeding $35 a barrel, the outlook for the Gulf currencies exchange rates remains quite stable with no pressure whatsoever on these currencies. The Kuwaiti dinar is undervalued against the dollar by 26 per cent indicating that the dinar has been pegged last year at a lower rate to the dollar than what its PPP suggests.
The Jordanian dinar is slightly undervalued by Big Mac standards. While inflation in Jordan is higher than that of the US, average prices especially those of services and non-tradable goods are much lower in Jordan. The surge in exports, rise in tourism and capital inflows boosted the country's foreign reserves to an all-time high of close to $5 billion and allowed the Central Bank to maintain throughout positive interest rates differentials to dollar interest rates. Given the country's positive economic fundamentals and the slightly undervalued Jordanian dinar, markets do not envisage any risk of devaluation anytime soon.
Intervention
The Lebanese pound at its current exchange rate of 1,512 to the dollar is 2 per cent undervalued by Big Mac standards. A tight monetary policy anchoring the Lebanese pound to the dollar with regular intervention in the forex market, maintaining an attractive interest rate differential in favour of the local currency and continuous capital inflows from the Lebanese diaspora have enabled the authorities to support the value of the currency at the slightly undervalued level with the country's foreign reserves exceeding $12 billion. However, the country's huge external debt suggests that devaluation risks for the Lebanese currency remain on the horizon.
The fact that all Arab currencies are undervalued against the dollar using the Big Mac index does not necessarily mean that these currencies are being held way below their fair value.
It is quite natural for average prices to be lower in less developed countries of the region compared to those in the US and therefore, for their currencies to appear cheap.
Burgers are not traded across borders, as the theory of purchasing power parity demands and prices are distorted by differences in the costs of non-tradable goods and services such as rents and labour cost. A haircut or a medical check up, for instance, is much cheaper in Cairo or Amman than in New York. This is why Arab currencies may not be as grossly undervalued as the Big Mac Index would suggest.
Converting the region's GDP into dollars at market exchange rates will significantly understate the true size of its economy, the region's living standards and its growth rates.
If we convert the total GDP of the Arab countries into dollars using the Big Mac purchasing power parity, it will be significantly higher than if GDP is converted at the market exchange rates. The region's growth rate would have also been much faster.
- Dr. Henry Azzam is the Jordan-based CEO of Jordinvest
Share this article
More from Business Opinion
More from Business
Popular in Business
-
Budget travel
Airlines in the region
Take a pictorial look at some of the budget airlines in GCC
Business Editor's choice
-
Experts seek solutions to global gloom
Suggestions formulated in Dubai will feature in next year's WEF
-
Qatar benefits from diversification
Doha's readiness to look beyond hydrocarbons as a growth engine bodes well
-
When the Web lives worldwide
Cutting-edge firms are building massive data facilities all over the globe
