Currency Valuation and Purchasing Power Parity Currency Valuation and Purchasing Power Parity Jamal Ibrahim Haidar Introduction The analytical framework of currency valuation is an intellectual challenge and of influence to economic policy, the smooth functioning of financial markets and the financial management of many international companies. The Economist magazine argues that its Big Mac Index (BMI), based on the price of a Big Mac hamburger across the world, can provide ‘true value’ of currencies. This paper provides ten reasons for why the BMI cannot provide a ‘true’ value of currency, and it proposes adjustments to specific misalignments. The purchasing power parity (PPP) theory postulates that national price levels should be equal when expressed in a common currency. Since the real exchange rate is the nominal exchange rate adjusted for relative national price levels, variations in the real exchange rate represent devia- tions from PPP. It has become something of a stylised fact that the PPP does not hold continuously. British prices increased relative to those in the US over the past 30 years, while those of Japan decreased. According to PPP theory, the British pound should have depreciated (an increase in the pound cost of the dollar) and the Japanese yen should have appreci- ated. This is what in fact happened. despite deviations in the exchange rate from price ratios, there is a distinct tendency for these ratios to act as Jamal Ibrahim Haidar is a consultant in the International Finance corporation of the World Bank. WORLD ECONOMICS • Vol. 12 • no. 3 • July–September 2011 1 Jamal Ibrahim Haidar Despite deviations in anchors for exchange rates. Thus, the exchange rate from exchange rate reverts to the price price ratios, there is a ratio, which can be considered the distinct tendency for these ‘true value’ of the currency. ratios to act as anchors In 1986, The Economist created for exchange rates. a tool for making PPP compari- sons. This tool uses the price of a Big Mac hamburger at home and abroad as the price ratio that reflects the ‘true value’ of the currency. This ratio represents the BMI; it is the nucleus of ‘burgernomics’. The BMI gives a signal about under-valuation and over-valuation of currencies, relative to the actual exchange rate. The PPP school of thought is among the oldest research areas in international finance. The PPP stands as a general form of the law of one price in the geographical arbitrage presence for the same goods at different location. The PPP holds only within strict circumstances – i.e. lack of central bank interventions, trade restrictions, transaction costs and taxes. A reference to PPP helps determine whether the foreign exchange market precisely prices a currency because a currency, typically, reverts to its PPP value over time. The BMI currency pricing model is well embedded in the PPP theory. It is a case of interaction between financial journalism, basic eco- nomic research and foreign exchange markets. This paper uses the occasion of the 25th anniversary of the introduc- tion of the Big Mac Index to provide a broad evaluation of its workings and performance. While the BMI is not perfect, it provides hints about the operation of foreign exchange markets. The second part of the paper provides a literature review of ‘burgernomics’, presents evidence about the BMI and summarises the PPP theory debate. After that, there is a discussion of a set of BMI methodological limitations, and clarification of the BMI bias. The paper ends with a conclusion section. Evidence to date The literature on PPP is large and growing. Froot and rogoff (1995), lan and ong (2003), rogoff (1996), Sarno and Taylor (2002), Taylor and Taylor (2004) and Taylor (2006) are a subset of available literature reviews on the matter. click (1996), ong (1997), and Pakko and Pollard (1996) are among the early contributors to academic research on the 2 WORLD ECONOMICS • Vol. 12 • no. 3 • July–September 2011 Currency Valuation and Purchasing Power Parity BMI, while more recent papers include chen et al. (2007) and clements et al. (2010). Empirically, studies found heterogeneous results while test- ing PPP. Frankel (1979) studied the correlation between exchange rates and inflation (proxied by cPI and then by WPI)1 in the 1920s, finding PPP-supportive results in hyperinflation economies. However, using the same inflation indicators, the same author, among others (Isard 1977; Frankel 1981), rejects PPP for developed countries during the 1970s. nonetheless, inflation and exchange rate non-stationarity invalidates these findings by showing the shortcomings of conventional testing methods. Meanwhile, more recent research (Wu & chen 1999; Pedroni 2004) has rejected PPP validity (i.e. real exchange rate mean rever- sion) by utilising cross-country datasets, while Frankel and rose (1996) empirically validated PPP existence. The above studies, which use cPI or WPI, have at least two shortcom- ings. First, non-tradable goods affect cPI and WPI relative usage across countries. Second, regardless of whether the law of one price holds in a certain market for a specific commodity, cPIs and WPIs behave differ- ently when consumption bundles are not identical, leading to PPP tests’ biased outcomes. Hence, these price indices can lead to heterogeneous results while testing PPP validity. recent studies have shifted their atten- tion to using another price index as a study target. cumby (1996) used The Economist’s BMI, given its uniform composition feature, as the Big Mac ingredients are identical across countries, to assess PPP. The use of the Big Mac decreases the estimation bias given that it meets the ‘identical good’ requirement in the law of one price testing process. However, it does not meet all the requirements of the law of one price – i.e. barriers to trade, wage rate, taxes and productivity differentials. Methodological limitations of the BMI Demand variability The demand for fast food varies across countries. For instance, the north American relationship with the Big Mac is much more ingrained into cul- ture than it is in Asian cultures. For this reason, a direct comparison using the Big Mac Index (BMI) has some problems. First, food regulations differ 1 The study considered PPP valid when the regression coefficient is 1. WORLD ECONOMICS • Vol. 12 • no. 3 • July–September 2011 3 Jamal Ibrahim Haidar across countries. For example, Switzerland and the euro area have much more strict food regulation laws (Switzerland in particular) than the United States. This means that the cost of ‘better’ beef or other parts of a Big Mac is higher in the euro area. Second, there is the social perception and price differential of Mcdonald’s in the In Ukraine, one of different countries. In Switzerland the places to meet and and much of Europe, Mcdonald’s relax is McDonald’s. is more of a ‘nice’ place. It is not surprising for Mcdonald’s in Europe to have multiple storeys and in Switzerland there are video game systems and lounges. In Ukraine, one of the places to meet and relax is Mcdonald’s. This means that, in general, the outlets are located in better places and have higher rent payments in Europe. Also, richer people visit Mcdonald’s in Switzerland and the euro area, and will continue to pay for such goods despite the price. In the United States, however, Mcdonald’s is typically a cheaper place to eat and restaurants would lose a lot more money by increasing prices than in European Mcdonald’s outlets. With such variations, the BMI perpetuates a false idea that a critical analyst can discover anything at all about PPP by comparing hamburgers. Product comparability The theory of purchasing power parity (PPP), the notion that a dollar should buy the same amount in all countries, implies that, in the long term, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. However, the United States, along with most developed economies, subsidises meat, bread (which is made of wheat), lettuce, tomato, eggs, potatoes and all farm products in a Big Mac burger. Also, these countries exercise protectionism on those products as well as adopt a mercantilist approach in the international market. So, how can a Big Mac be a comparable item? For any product to be useful for that purpose, it should be freely tradable between countries, with no country subsidis- ing or taxing it more than another country. Therefore, the Big Mac is less appropriate as an item for price comparison since it would be cheaper in countries that subsidise farm products – and this may lead to a distorted comparison. 4 WORLD ECONOMICS • Vol. 12 • no. 3 • July–September 2011 Currency Valuation and Purchasing Power Parity Exchange rate predictability A ‘weak’ currency, despite its appeal to exporters and politicians, is no free lunch – but it can provide a cheap one. In china, for example, a Mcdonald’s Big Mac costs just 14.5 yuan on average in Beijing and Shenzhen, the equivalent of $2.18 at market exchange rates. In the US, in contrast, the same burger costs, on average, $3.71. A difference of this significance makes china’s yuan one of the most undervalued currencies in the most recent BMI, leading to currency misalignments. Since the BMI is based on the idea of PPP, and 14.5 yuan can buy as much burger as $3.71, a yuan should be worth $0.26 on the foreign exchange market. In fact, it costs just $0.15, suggesting that it is undervalued by about 40%. In Brazil a Big Mac costs the equivalent of $5.26, implying that the real is overvalued by 42%. The index also suggests that the euro is overvalued by about 29%.