Now … did you know that if the United States spent its entire annual income this year on Big Macs (USD18.5tln according to the IMF) it would equate to nearly 3.7 trillion burgers at just over USD5 each? So, we know the Americans love their fast food, however even 3.7m trillion Big Macs would not make them the global leader for the most Big Macs bought using a country's entire income. That award would go to China. Although China’s GDP is around USD11.3tln (approximately 73tln yuan), the McDonald's trademark burger only costs just under 19 yuan (USD 2.78 at time of writing) on average in China, which equates to over 3.9tln burgers. Now bear with us, there is a point to all this as we wait for the FOMC this evening, however as you see, by one measure at least, China has overtaken the US as the biggest economy in the world. (Well in Big Mac terms!!)
The Big Mac index calculates the price of the burger (the whole burger, bun and gherkin included!) to estimate the competitiveness of the underlying currency. It was invented by The Economist in 1986 as a light hearted guide to whether a country's currency is either undervalued or overvalued. The underlying theory behind it is based on purchasing-power parity (PPP), the idea being that in the long run all exchange rates should move towards being equal for goods and services that are identical in different countries. Why a Big Mac you ask, well, Ronald McDonald, for all his global domination, keeps that same recipe for its trade mark burger the world over, as we all know you can go into a Mcdonald's anywhere in the world, point to a Big Mac and know exactly what you are getting! The only exception to this is India where the beef is replaced with chicken, for obvious reasons. So the fact that a Big Mac costs you USD2.78 in China (at time of writing) and just over USD5 in the US (at time of writing ) would indicate that the Chinese currency is undervalued by just under 45%.
Although the index was set up as a tongue in cheek guide to currency values, it has since become something of a global standard, used in economic studies and academic papers. However, we do now have Nomura’s IPhone index that suggests the US dollar is undervalued. The typical IPhone in the State's costs $649, $705 in the UK and $1,213 in Brazil, according to the index and so the US currency is cheap in IPhone terms.
But analysing currencies using the Big Mac or the Iphone index alone can lead to the wrong conclusions. In fact, Big Mac’s should be cheaper in poor countries and more expensive in richer ones. This misunderstanding is why so many people get their currency forecasts wrong. The renminbi is undervalued, but not by as much as 45%. However, as Chinese growth is likely to be stronger than most of the rest of the world for the foreseeable future, its undervaluation versus PPP will reduce. A simpler way of putting this is that the renminbi is likely to appreciate for many years and the US, with its high and growing net foreign liabilities, is likely to decline.This is not what a casual reading of the Big Mac Index would lead one to conclude.