When an asset achieves the status of ‘fair value’ it generally ceases to be news, which is probably why no-one has been talking about the Australian dollar reaching that point against the US dollar (which it has according to the Big Mac index).
While not an official measuring tool, over time the Big Mac index has proved to be a fascinating measure of international currency values and can be more accurate than anything produced by big name investment banks.
If the latest reading of the index is correct and there really is a minimal 1.4 per cent difference between the Australian and US currencies, then an important signal is being sent to importer and exporters, as well as anyone planning an overseas holiday.
For Western Australia’s all-important mining industry, the fall in the Big Mac index to near parity means that the best of the exchange rate benefit from minerals sold in US dollars is already factored into local prices, which will not please anyone hoping for a further fall in the Australian currency.
For international holiday makers the index is signalling that there’s no need to pay now in fear of a further decline in the Australian dollar pushing up your travel costs – though whether you’re prepared to trust a measuring tool based on the price of a hamburger is another question.
Invented by The Economist, a British business magazine, the Big Mac index compares the prices of a basic McDonald’s hamburger in 45 countries and regions and uses that data to calculate whether a currency is over or undervalued.
The index is based on the theory of purchasing power parity, a belief that, in the long run, exchange rates should move towards a rate that would equalise the prices of an identical basket of goods and services in any two countries.
The Economist chose a McDonald’s hamburger because it is available in most countries, easy for non-economists to understand, and to lighten the ‘dismal science’, which is a nickname for economics.
In Australia’s case, the index has been accurately tracking the overvaluation of our dollar during the past couple of years, a point well understood by farmers and miners.
Between 2009 and today the index, in its raw form, showed the Australian dollar to be overvalued by up to 25 per cent thanks to weakness in the US dollar, the effects of the resources boom, and the magnetic appeal of the Australian currency for international investors seeking safe havens.
From its peak overvaluation in mid-2011 the Big Mac index has been moving down, reaching a 10 per cent overvaluation position earlier this year, and is now at its near-parity reading of being just 1.4 per cent overvalued.
Interestingly, and in keeping with the reputation of economists having multiple explanations for seemingly simple concepts (ask five for an opinion and get six answers), it can also be argued that the index already shows the Australian dollar to be undervalued.
A case for undervaluation can be argued if an adjustment is made for the wealth of a country on a per-capita basis.
As the US is richer per head of population than Australia, the adjusted Big Mac index shows that the Australian dollar is undervalued by around 12 per cent, which is another indication that the exchange rate fall this year from around $US1.05 to its current US92c might be as far as it goes.
According to the index, the country with the most overvalued currency is Norway, with the krone said to be more than 60 per cent overvalued, followed by Venezuela, Switzerland and Sweden.
The country with the most undervalued currency is India, with the rupee calculated to be more than 65 per cent undervalued, followed by the currencies of South Africa, Hong Kong and Malaysia.
