I have discussed the pros of capitalising undervalued foreign currencies by travel to another lower costs city/country via Quasi Geoarbitrage and buying more foreign currencies by taking advantage of foreign currencies drops.
However, how would we know if the foreign currencies are under- or over- valued relative to our local currencies?
The Big Mac Index was created by The Economist in 1986 to measure Purchasing Power Parity (PPP) between countries.
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 any two countries.
The burger here replaces the “basket of goods” traditionally used to measure differences in consumer pricing.
Many economists say it is roughly accurate.
I have been eating Big Mac burgers for as long as I could remember. From as low as $3.20 back in year 2000, the same burger (with the same ingredients and taste) now cost $5.80. An 81% increment over 20 years or annualised inflation rate of 3.02%.
Singapore is always trying to fight for the top positions in the world. It is of no surprise that we have steadily moved up the ranks to become ranked 12th for the most expensive Big Mac in the world. Ouch, next!
Switzerland and Norway have consistently been producing the most expensive Big Macs for the past 10 years. I was in Switzerland earlier this year, and I can assure you I ate a Hamburger meal instead – it was equally satisfying on my stomach and wallet.
According to PPP theory, any changes in exchange rates between countries shall eventually be reflected in a change in the price of a basket of goods over time. Yet a basket of goods in one country can rarely be precisely duplicated in another. For example, an Canadian versus Korean basket of groceries are likely to contain very different products.
A Big Mac, though, is always a Big Mac.
Now here is the fun part. Investors can use the Big Mac Index to determine if a currency is overvalued or undervalued relative to others and trade based on that data in foreign exchange market. Similarly, changes in values over time could be used to determine inflation rates and compare against official records. 3.02% inflation rate, anyone?
The Big Mac Index is not a perfect instrument. As of mid-2019, out of 195 countries, McDonald’s has outlets in only 119. Thus, the methodology cannot analyze PPP between the Singapore dollars against Icelandic krona or Bolivian boliviano, among others.
Nevertheless, it may be a fairly accurate real-world indicator of economics and purchasing power, since the pricing of a Big Mac must take into account local costs of raw materials, labor, production, advertising, taxes etc. But investors should remember that there are some important exceptions to the rule.
So I crunched some data based on Big Mac local pricing, the Big Mac exchange rate versus Singapore for each country and the foreign exchange rate versus Singapore dollars.
The higher the percentages, the more undervalued is the foreign currencies relative to Singapore. This is also indicative of which countries are more worth of travelling should we want to leverage on Singapore dollars strong currency.
Based on the Big Mac Index, the Malaysian ringgit was undervalued by 49.90% against the Singapore dollar in July 2019.
The Big Mac Index has become a global standard for price comparison. One can use it to track local purchasing power internationally. For example the same Big Mac while being super expensive in Switzerland, is frightfully cheaper in Russia.
As for me, I will grab my Big Mac any time when I hope over to Johor Bahru, Malaysia. Are you convinced?
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