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Puzzled by the dollar outlook? Buy a Big Mac
Foreign exchange markets are notoriously difficult to bet on.
To do so, you have to decide whether one currency is over- or under-valued in relation to another. For that, you'll need econometric models made up of hundreds of algorithms built by rocket scientists.
Or you could just go buy a lot of Big Macs. And charge them to your expense account.
That's the currency valuation model set up by the editors at The Economist magazine where, now twice a year, they dispatch staffers around the world to their nearest McDonald's (NYSE: MCD) and order a Big Mac. And according to the latest Big Mac Index, the value of the dollar continues to fatten in much of the fast-food eating world.
The index is based on the idea that the rate of exchange between currencies should reflect the price people pay for the same goods and services from one country to the next. Economists call this the theory of purchasing-power parity.
The Economist looks at just one item, a Big Mac, in several dozen countries around the world as a standard measure of value. (The index isn't perfect; in India, they don't serve Big Macs, so the editors had to substitute a Maharaja Mac, which is a chicken sandwich.)
By converting the local prices into dollars, the index provides an indication of whether the dollar is over- or undervalued in a given country. The more you have to pay for the same Big Mac in a given country, after adjusting for the value of the dollar, the more the U.S. currency is undervalued in that local economy.
For example, the average price of a Big Mac in the U.S. this month was $4.79; in China it was only 17 yuan, which works out to only $2.74 based on market exchange rates. So that price differential indicates that the yuan was undervalued by 43 percent.
Based on local purchasing power, the cheapest Big Mac-valued at 67 cents in dollar terms-could be bought in Venezuela, where the local currency, the bolivar, is undervalued by 86 percent against the dollar, according to the index. Since last year's crash in oil prices left the oil-dependent economy on life support, Venezuelan officials have been propping up the value of the bolivar to prevent a wider economic collapse.
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On the other hand, if you're in Geneva and crave a Quarter Pounder, you'll have to shell out $6.82 worth of Swiss francs. That means the index indicates that the local Swiss francs currency is overvalued by 47 percent. The Swiss franc became hotter than a batch of freshly cooked fries last year after Switzerland's central bank triggered a stampede into its currency by scrapping its cap on the exchange rate against the euro.
The magazine has made semi-annual events of their burger binge since 2000, tracking the dollar's ups and downs around the world. The latest reading indicates that-with Federal Reserve officials signaling that U.S. interest rates are heading higher later this year, the global value of the dollar has been rising. Of the 44 currencies tracked by the index, 39 are undervalued relative to the dollar as of this month.
The keepers of the index concede the methodology has limitations. Aside from exchange rate fluctuations, for example, local prices can also be skewed by the relative demand for burgers in a given country, where local cuisine and tastes vary widely.
Still, in the nearly three decades they've been munching their way through the ups and downs of exchange rates, the index has been cited in economic textbooks and studied by academics.
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As a result, it's been refined over the years to address some of its critics. The average price of a burger, for example, should be cheaper in poor countries than in rich ones because labor costs are lower-so the adjusted index now takes per capita GDP into account.
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