Currency Value and The Big Mac Index Farce

CNBC recently, Friday, July 24, 2015 to be exact, published the following article:

Puzzled by the dollar outlook? Buy a Big Mac

Here is the link: http://www.cnbc.com/2015/07/24/puzzled-by-the-dollar-outlook-buy-a-big-mac.html

First, no thanks.  Not interested in a Big Mac.  Second, let’s just say that some statements and claims in the piece jumped out and deserved a second look.

“Foreign exchange markets are notoriously difficult to bet on. To do so, you have to decide whether one currency is over- or under-valued in relation to another. For that, you’ll need econometric models made up of hundreds of algorithms built by rocket scientists.

“By converting the local prices into dollars, the index provides an indication of whether the dollar is over- or undervalued in a given country. The more you have to pay for the same Big Mac in a given country, after adjusting for the value of the dollar, the more the U.S. currency is undervalued in that local economy.

“For example, the average price of a Big Mac in the U.S. this month was $4.79; in China it was only 17 yuan, which works out to only $2.74 based on market exchange rates. So that price differential indicates that the yuan was undervalued by 43 percent.”

Wow, that last one was a whopper (not to confuse Burger King with McDonalds), the yuan is undervalued by 43%???  Sounds like an opportunity to me, or is it?

First, the yuan does not trade freely among other world currencies.  To be fair, no currencies do as their governments and central banks are constantly intervening in the foreign exchange and interest rate (bond) markets doing their best to modify what the market determines to be fair value for their currency and sovereign debts.  But, let us focus on the claim that analyzing the US dollar cost of a Big Mac globally can tell us whether or not currencies are over or undervalued and whether or not we should use the Big Mac Index as a tool to make investment decisions.

Of course, this was not a CNBC constructed study.  They simply get their information from other sources and regurgitate it, expel it and/or propel it.  The original source is The Economist.  They “invented” (their word , not mine) the Big Mac index in 1986 as “a lighthearted guide to whether currencies are at their “correct” level”.  Again, their words, not mine.

The latest installment can be found here:

http://www.economist.com/content/big-mac-index

Someone please correct me if I am wrong, but do we not already have global commodities that trade on supposed unfettered free market exchanges?  Why are we then substituting the Big Mac (commodity, again their words) for copper, oil, precious metals, etc. to glean information on currencies?  I fail to see how this makes any sense. The Big Mac Index measures much more than a Big Mac. It measures the cost of beef, flour, vegetables, dairy products, real estate, taxes, regulations, transportation, labor,etc., and to some degree, currency “value”.  If certain currencies were over or undervalued to the degree The Economist is saying they are, then there would be massive highly profitable arbitrage and/or carry opportunities all over the globe going completely undetected by traders that make knowing this information their livelihood.  Not that opportunities do not exist, they are simply not going to be found using the Big Mac Index.  Which they clearly admit:

“Foreign exchange markets are notoriously difficult to bet on. To do so, you have to decide whether one currency is over- or under-valued in relation to another. For that, you’ll need econometric models made up of hundreds of algorithms built by rocket scientists.

Let’s examine this more closely and look just in the US for a moment.  There are 50 states, and a few more territories, but prices for a Big Mac could vary wildly even in the United Sates.

http://www.nerdwallet.com/blog/cities/economics/quarter-pounder-index-most-least-expensive-cities/

In fact, in their May 12, 2013, article, Nerdwallet concluded that:

“A McDonald’s burger costs more than twice as much in Juneau, Alaska as it does in Conway, Arkansas ($4.82 vs $2.24).”

So, just in the United States, the cost of a Quarter Pounder, in the Nerdwallet study, can cost over 2 times as much in one city versus another.  And, of course, this has nothing to do with the value of the US dollar.  It has everything to do with the individual components that make up the cost of the retail cost of a burger.  Just one component, wages.   Per The Bureau of Labor Statistics, the average annual wage in the United States is currently $47,230.

http://www.bls.gov/oes/current/oes_nat.htm#00-0000

00-0000 All Occupations total 135,128,260 0.1% 1000.000 $17.09 $22.71 $47,230 0.1%

In China, the comparable figure is $9,067.  Perhaps it can be stated that a US dollar can go further, stretched farther, and is worth more in Conway, Arkansas and, on the average, in China, but this has nothing to do with the value of the currency compared to another and any conclusion reached to the contrary would be based on a foundation of quicksand.

Let me break it down this way.  If it were true that the yuan is undervalued by 43%, a fantastic opportunity would exist in converting US dollars to yuan and waiting to earn your 43% upon re-conversion back to dollars.  Well, the problem with that is that the popular consensus among the most knowledgeable on the subject matter is that the yuan has been overvalued, not undervalued, against the US dollar.  And, that continuing to peg to the strong dollar is and will continue to place added pressure on the Chinese economy, already suffering from a stimulus hangover.  Well, sure enough, fast forward to August 11, 2015:

China’s ‘big bang’ dents global markets

http://www.cnbc.com/2015/08/11/chinas-big-bang-dents-global-markets.html

The first sentence completes the farce: “Investors around the world were taken by surprise on Tuesday after the People’s Bank of China (PBoC) devalued the yuan by almost 2 percent against the U.S. dollar, causing the currency to suffer its biggest fall in over two decades.”  The first sentence should read, “Everyone who knows what the hell they are talking about were not surprised at all by the yuan devaluation.  The people we count on for information were completely wrong about the value of the yuan because their Big Mac Index really sucks at determining what the fair value of a currency should be – but what the hell, we will continue to use them anyways.”

Folks, you really, really, have to be careful where you get your information!


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