/ 5 February 2003

Have a Big Mac

This week two indicators told differing stories about the value of the rand, while offering insights into the currency and its exchange value.

Absa declared that the currency was “probably overvalued”, without saying by how much.

The Economist/Big Mac index signalled that the rand was still undervalued by 30%.

Absa chief economist Christo Luus employed a model using capital inflows as percentage of gross domestic product, the value of the dollar, the inflation rate and the difference in interest rates between the United States and South Africa to conclude that the rand should probably trade at an average of R7,56 to the dollar in the second quarter and settle at R8,48 towards year-end.

Luus notes: “Although purchasing power valuations of the rand generally indicate that the rand could strengthen further, technical and fundamental economic factors mitigate against this.”

Luus’s comment relates to the Big Mac index, which is based on the concept of purchasing power parity — PPP.

The concept holds that exchange rates across two countries must move in line with the price of a basket of common goods and services in their respective economies. The same idea applies to interest rates.

When prices or interest rates are too far apart, room is created for arbitrage. One can buy (or borrow) where prices (or interest rates) are lower and sell (or lend) at a higher price (or rate) and pocket the difference. When that happens, prices or rates move to close the gap.

The Big Mac index takes the McDonald’s Big Mac and treats it as a common basket of goods across 43 countries. Prices are converted into dollars and compared to the US price, and a currency is deemed undervalued against the dollar if it is below the US price, overvalued if above.

On April 25, at an exchange rate of R7,30 to the dollar and a price of R13,95, a Big Mac in South Africa cost $1,91. This is 30% below the US price of $2,71. It also contrasts with the US72c it cost on December 20 2001, when the rand touched a historic low-point of R13,86 to the dollar at a Big Mac price of R9,95. The rand would have to trade at R5,15 to the dollar to achieve parity.

At April 22 exchange rates, China is the cheapest place to buy a Big Mac at $1,20, while in Iceland it will set you back $5,79, the world’s most expensive.

A huge limitation with the Big Mac index is that input costs across countries differ widely.

For the index to be a perfect measure, inputs would have to be produced at the same place and transported across the world at no cost and without trade barriers.

As is clear from the above, economics is far from being an exact science. You pays your money, and you takes your chance …