Sunday, October 17, 2010

The Limits of the Big Mac Index: Is the Yuan really 40 percent undervalued?




I like to thank my friend Ahmed Aouam from Morocco for showing us this new article from The Economist about the well-known 'Big Mac Index'. The Big Mac Index is not an indicator of revenues at McDonald's but it is an alternative inflation/currency value indicator created to measure purchasing power in different countries.

The purpose: by calculating the price of the Big Mac per country and comparing it with the US price one gets an idea of 'value'. Not value as in something intangible, but as in something tangible, tasty and very bad for your health.

There were times that the index really did great. That was during a period in which central bureaus of statistics in various countries would all analyze their purchasing power using different baskets of consumer and other goods. But Bureaus of Statistics can change those baskets. Unfortunately over time - with growing international relationships and a growing interest in international comparisons - they started to change baskets and not always for the good reasons. They found out that one could change the basket to make a better case for whatever inflation stand the government had. Yep: how to lie with statistics.

That is the time when the Big Mac Index was created as a kind of flawless indicator. But it is not, unfortunately.


The limits of the Big Mac Indicator

Why not? Well, if you compare the prices of the Big Mac in various countries you assume that the 'value' to consumers is similar across the globe. However, in some countries the association with American junk food is cooler than in others. In some countries the association with 'American' is cool in-and-of-itself, whereas in others it is the enemy!

The Swiss number one spot is no big surprise. The American association is not negative and whenever you have tried to shop or eat around in Zurich - try the area around Paradeplatz where the two big banks have their private banking headquarters! - you know that everything is expensive there. And when everything is expensive so is the Big Mac, especially so in a country that specializes in providing services to people that bring money. Often they arrive with cash in their own currency, then translate that into Swiss Francs (i.e. demand for the Swiss currency), and treat their Swiss trip as a kind of 'useful holiday' (enjoying the beautiful country while doing money business).

Zurich Paradeplatz: Big Banks dominating Big Macs

Add to that the fact that Switzerland is one of those countries with a tax system with a relatively high percentage of direct taxes (VAT, levies on goods etc) and a relatively low indirect tax rate and you can understand their leading position. And that everything is different there.

Big Mac Index Oct 2010 - Selected Countries

It is interesting to see in the list, when reading from the top down, that most 'Western' or 'Westernized' countries are also in a relatively high position. The countries where kids have introduced 'Oh my god' as a line in their own language, watch The Kardashians, X Factor, Idols and listen to American music. Higher relative value of the Big Mac is the result. Of course! The supply-demand position is also to some extent influenced by this 'American' factor that will lead to higher demand and/or a willingness to pay higher prices than in the US. After all: the country where being American is not really a priced factor is the US itself, where still almost everything is American (export and import are small, TV fully dominated by what is going on in the US on its own soil). With respect to the latter: I recall that during my days in California a call to my mom in Holland gave me more information about what was going on in Iraq than watching TV or reading newspapers in LA. Michael Jackson and others dominated the news and war was sadly enough more interesting when it was about movies with Sean Pean or you name them than about your own soldiers.

Is the Yuan really 40 percent undervalued?



So is the Chinese currency undervalued by 40 percent based on the index? The calculation is right, but the conclusion is not.

Whenever you check out the internet, where Chinese population dominates - the Chinese online population is the biggest in the world with more than 425 million internet users - we do not have much contact with them unless you know Chinese. Censorship is still a factor, and although they are gradually but slowly becoming westernized an earlier research report that we wrote about on the LMG Emerge Facebook Page indicated that Chinese do like Western luxury. But whenever they like luxury item A they will compensate by paying less for luxury item B and/or even some of the non-luxury items. Everything with the idea of showing status.

Status is in the watch, the clothes, the cars, fancy restaurants. Not in going to McDonald's. So totally possible that it translates into a negative 'US factor' when calculating it via the Big Mac. Also totally possible that it translates into a positive 'Western Market' factor when calculating it via Prada or Gucci or Cartier.


Why the Big Mac Index has limited value when measuring purchasing power in China


Conclusion: globalization and a more heterogeneous world have translated into the famous Big Mac indicator being less useful than ever before. It is a pity, because it was fun. We do like the CONCEPT however and believe that the good old basket idea, but now one that we keep stable as long as it is realistic, and one derived for a global Average Joe is a better way to check if one or the other currency is over- or undervalued. Or even one calculated based on consumption baskets per country, as long as there is a good 'story' when opting for basket changes. With some international committee analyzing those changes.

Conclusion2: but even then. It could also mean that something else is going on. With the Fed and Bernanke stimulating the US economy through an easy money policy waves of cheap dollars flood the world. That will put downward pressure on the US dollar. But to the extent that other countries are still willing to keep their accounts in US dollars one can also conclude that the Dollar is overvalued! Especially so when knowing about a well known phenomenon that Gold and US Dollars are still seen as safe haven internationally. When something goes wrong with your country or currency, what are the ultimate safe havens? Yep, gold is gold and it will keep its value. Money is paper, but the US paper is interesting. Why? In the US the value of a dollar is always a dollar and when I am in danger in my own country I can move to the US and problem solved. And the Swiss? When I am afraid of what is going on in the world I can bring my money to Switzerland and live my life anywhere across the globe, feeling happy that my money is well taken care off.

This story is a bit more complicated than taking a bite of your Big Mac. It was a nice story but we need to work it out further if we ever want to conclude who is right: the Americans or the Chinese. But the bottom-line is probably that both do have a point. One is trying to keep its currency low because of its export machinery and the other is flooding the market with cheap dollars in an effort to kick-start its economy. The LMG position is that Western countries have to accept that China is in the driver's seat and that a Chinese investor or shareholder is just that: a market participant with money and purchasing power. Xenophobia and paranoia will translate into currency pressure that might lead to a continuation of economic problems across the globe. And with those problems in the West currently bigger than those of China and other Emerging Countries this is self-defeating.

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