Vantage View: Valuing Arab currencies with Big Mac

The Big Mac index was devised by The Economist magazine in 1986 as a light-hearted indicator of whether currencies are at their "correct" valuation level.

This innovative notion, referred to by The Economist 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 U.S. 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 U.S., i.e. 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.

The first column of the table (right) 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 $2.71.

The cheapest Big Mac in the region is in Egypt at $1.38, while the most expensive is in Lebanon at $2.84.

By this measure, the Egyptian pound is the most undervalued currency and the Lebanese pound is overvalued.

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 0.66 Jordanian dinar, seven per cent lower than the actual exchange rate of 0.71 Jordanian dinar. This implies that the Jordanian dinar is seven per cent undervalued.

Last year, the Big Mac index indicated an undervalued euro to the dollar. The European currency has risen since then by 15 per cent to $1.14 to the euro (0.88 to the dollar), compared to a purchasing power parity of one euro, to the dollar.

The index suggests that the euro has now become 14 per cent overvalued compared to its PPP (Big Mac in Europe is 14 per cent more expensive than in the U.S.).

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 testing the $1.20 in the months ahead.

However, the Big Mac index is flashing an overvalued European currency which could bring the euro down back to its parity with the dollar one year down the road.

According to the Big Mac index, the Egyptian pound is significantly undervalued against the dollar by 49 per cent, with a PPP of EGP 2.95 to the dollar compared to the current exchange rate of EGP 5.8 to the dollar.

However, market forces indicate otherwise with a widening balance of payment deficit and recurrent shortage of dollars in the exchange market putting downward pressure on the pound.

The Egyptian government's adoption of a floating exchange rate policy on January 29 this year has failed to eradicate the black market for the Egyptian pound whose value continued to slide in the exchange market. While the official rate is now at 5.80 pounds to the dollar, compared to 5.40 just after the float, the black market rate is closer to 6.35 pounds to the dollar.

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 11 per cent and 10 per cent respectively.

However, with oil prices trading at $24 a barrel, the outlook for the Gulf currencies exchange rates remains quite stable with no pressure whatsoever on the two currencies.

The Kuwaiti dinar is undervalued against the dollar by 20 per cent, indicating that the dinar has been pegged at a lower rate to the dollar than what its PPP suggests.

The Jordanian dinar is slightly undervalued by Big Mac standards despite the country's strong macroeconomic performance over the past three years, with economic growth averaging around 4.5 per cent.

Inflation in Jordan, even though it has been on the decline, is still higher than that of the U.S., while the kingdom's budget deficit/GDP ratio has slightly increased last year.

Nevertheless, more privatisation deals and the surge in exports especially from the QIZ boosted the country's foreign reserves to an all time high of $3.5 billion and allowed the Central Bank to reduce interest rates on the Jordanian dinar while maintaining throughout positive interest rates differentials to dollar rates.

Given the country's positive economic fundamentals and the slightly undervalued Jordanian dinar, markets do not envisage any risk of devaluation any time soon.

At the other end, the Lebanese pound at its current exchange rate of 1,512 to the dollar is 5 per cent overvalued 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 a slightly overvalued level with the country's foreign reserves exceeding $10 billion.

However, the country's huge external debt suggests that devaluation risks for the Lebanese currency remain on the horizon.