Big Mac Index: Europe overvalued, Asia undervalued
The Economist released its remarkably telling Big Mac Index this past weekend. The index looks at the relative cost of Big Mac in various countries to gauge how over- or undervalued the currencies in those locales are. Judging from this Index, there are some monster distortions in the currency markets right now.
The numbers marked in red are the areas I would like to highlight. They are representative of massive currency overvaluation in Europe (+72% in Norway, +55% in Denmark, +29% in the Eurozone) and absurd levels of undervaluation in Asia (-49% in China, –52% in Hong Kong, –47% in Malaysia and –42% in the Philippines). One might argue the European overvaluation represents a repudiation of the U.S. dollar. Sterling is only +3% versus the Dollar in the index, so that suggests a repudiation of the Pound as well.
On the other hand, Asian currencies are generally not floating but rather fixed via dirty float to the U.S. dollar. For example, the Malaysian ringgit and the Chinese renminbi are two currencies with a managed float. So, the undervaluation of Asian currencies is a political decision of mercantilist economic policy in the region. This has been a major cause of the fabled Asian savings glut and large current account surpluses in Asia. In my view, this as also been a major source of instability in the global financial system.
Clearly, Bretton Woods II has outlived its usefulness.
Source
The Big Mac index: Cheesed off – The Economist
I believe that the Big Mac Index has shown Nordic currencies to be overvalued ever since the index was concieved.
Big Macs are more expensive in the Nordic countries due to higher salaries and taxes than in most other countries. For example, the minimum wage in Denmark is approx $15/hour, VAT is 25% and personal income tax is approx 45-60%.
Of course you can still argue that the currencies are overvalued, they may well be, but that doesn’t help you much if you have to wait a lifetime before there is a correction.
The Big Mac Index is interesting and a good starting point for further analysis, but it is a terrible tool as a stand alone basis for investment or speculation decisions.
Michael, although I said “one might argue” in regards to European currency overvaluation, I do agree with your points that a high cost of living in Western Europe is the large part of why there is overvaluation there using a PPP proxy like this index.
The lack of a British overvaluation where costs are also high, however, does suggest that other issues are at play as well.
My focus was more Asia here and the managed float of many currencies there. Here, the undervaluation is coerced by government policy. And that is a problem.
Michael, excellent point…
One should not bet against European currencies because they have a welfare state, high taxes, etc. I also pointed this out at the Pragmatic Capital blog.
One could argue that the wages in the PIGS countries are too high and not “competitve” because of a strong euro, and this makes the currency overvalued. I also think the Euro will fall against the dollar because the dollar would be propped up in the debt deflation environment, and the low interest rate environment in the Eurozone would make it a less attractive place for capital inflows.
good points, especially on
“One could argue that the wages in the PIGS countries are too high and not “competitve” because of a strong euro, and this makes the currency overvalued”
This is why Spain and Ireland are in depression.