Watch your BMI, London’s The Economist advised last week as it updated its Big Mac index—what it calls its lighthearted guide to currency valuation.
For NZ this has special meaning, because since January the NZ dollar has moved from being 17% to 23% undervalued, according to the BMI.
The Big Mac index, invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level, is based on the theory of purchasing-power parity (PPP).
This is the notion that – in the long run – exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries.
A Big Mac costs NZ$6.20 in NZ and US$5.51 in the US. The implied exchange rate is 1.13. The difference between this and the actual exchange rate, 1.46, suggests the NZ dollar is 23.2% undervalued.
By comparison in January the Big Mac was worth $6.20 in NZ and $5.28 in the US. The implied exchange rate then was 1.17. The difference between this and the actual exchange rate was 1.37, suggesting the NZ dollar was 16.6% undervalued.
In the latest update, NZ is in good company, with Singapore’s currency 23% and the UK pound, similarly at 23%, undervalued.
Since the January BMI NZ’s currency has moved down more sharply than in Singapore and the UK, but the downward swing has not been as great as for the Argentinian peso which slid from 25% to 51% undervalued.
The Economist also publishes a GDP-adjusted index to address the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower.
PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today’s equilibrium rate.
The relationship between prices and GDP per person may be a better guide to the current fair value of a currency, The Economist says.
On this measure the NZ dollar is 9.9% undervalued, whereas Britain’s pound is 8.4% undervalued and Singapore’s currency is 21.2% undervalued.
The Economist says burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible
The need to understand the theory and set the right economic policy settings is important.
As a noted international economist once said: “Since the exchange rate is the most powerful policy instrument with which to provide incentives for exporters, its maintenance at realistic levels which provide an incentive to producers to export is crucial to success”.