How fast is the world economy growing? How important is China as an engine of growth? How much richer is the average person in America than in China? The answers to these huge questions depend crucially on how you convert the value of output in different countries into a common currency. Converting national GDPs into dollars at market exchange rates is misleading. Prices tend to be lower in poor economies, so a dollar of spending in China, say, is worth a lot more than a dollar in America. A better method is to use purchasing-power parities (PPP), which take account of price differences.
The theory of purchasing-power parity says that in the long run exchange rates should move towards rates that would equalise the prices of an identical basket of goods and services in any two countries. This is the thinking behind The Economist’s Big Mac index. Invented in 1986 as a light-hearted guide to whether currencies are at their “correct” level, our “basket” is a McDonalds’ Big Mac, which is produced locally in almost 120 countries.
The Big Mac PPP is the exchange rate that would leave a burger in any country costing the same as in America. The first column of our table converts the local price of a Big Mac into dollars at current exchange rates. The average price of a Big Mac in four American cities is $2.90 (including tax). The cheapest shown in the table is in the Philippines ($1.23), the most expensive in Switzerland ($4.90). In other words, the Philippine peso is the world’s most undervalued currency, the Swiss franc its most overvalued.
The second column calculates Big Mac PPPs by dividing the local currency price by the American price. For instance, in Japan a Big Mac costs ¥ 262. Dividing this by the American price of $2.90 produces a dollar PPP against the yen of ¥ 90, compared with its current rate of ¥ 113, suggesting that the yen is 20% undervalued. In contrast, the euro (based on a weighted average of Big Mac prices in the euro area) is 13% overvalued. But perhaps the most interesting finding is that all emerging-market currencies are undervalued against the dollar. The Chinese yuan, on which much ink has been spilled in recent months, looks 57% too cheap.
The Big Mac index was never intended as a precise forecasting tool. Burgers are not traded across borders as the PPP theory demands; prices are distorted by differences in the cost of non-tradable goods and services, such as rents.
Yet these very failings make the Big Mac index useful, since looked at another way it can help to measure countries’ differing costs of living. That a Big Mac is cheap in China does not in fact prove that the yuan is being held massively below its fair value, as many American politicians claim. It is quite natural for average prices to be lower in poorer countries and therefore for their currencies to appear cheap.
The prices of traded goods will tend to be similar to those in developed economies. But the prices of non-tradable products, such as housing and labour-intensive services, are generally much lower. A hair-cut is, for instance, much cheaper in Beijing than in New York.