The latest update to The Economists’ Big Mac Index for mid-year 2020 shows that the rand is currently the most undervalued currency in the world.
The Big Mac Index is an initiative created by The Economist that aims to measure whether currencies are priced at their “correct” level.
It is based on the theory of purchasing-power parity (PPP) – the notion that, in the long run, exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a Big Mac burger) in any two countries.
The Big Mac is selected for comparison as the popular fast-food meal is widely available across the world, and remains fairly consistent in pricing; however, it is by no means an exact science.
According to The Economist, ‘Burgernomics’ was never intended as a precise gauge of currency misalignment, but merely a tool to make exchange-rate theory more digestible.
The index has however, become a global standard, included in several economic textbooks while also becoming the subject of at least 20 academic studies, the group noted.
The ‘real’ value of the rand in July 2020
The Big Mac Index measures the real value of currencies using two methods – a direct measure of PPP using raw prices, and an adjusted index that takes into account local GDP data.
Using the raw data, a Big Mac costs R31.00 in South Africa and $5.71 in the United States. The implied exchange rate is R5.43 to the dollar.
The difference between this and the actual exchange rate – R16.67 to the dollar – suggests the South African rand is undervalued by 67.4%, which is the most undervalued currency measured by the index in July.
The full picture
However, the raw index does not tell the full story of currency valuation.
Because many argue that, due to PPP, the cost to produce a Big Mac is cheaper in poorer countries than in richer ones, The Economist factors in another important indicator – GDP per capita – to draw a more accurate conclusion.
In this adjusted index, South Africa’s currency still remains heavily undervalued, but less so than when dealing with the straight conversion data, ranked as the third most undervalued, rather than the most undervalued.
In PPP terms, a Big Mac costs 67% less in South Africa ($1.86) than in the United States ($5.71) at market exchange rates.
Based on differences in GDP per person, a Big Mac should cost 44% less ($3.19). This suggests the rand is 41.3% undervalued, and should be at R9.32 to the dollar.
Using this measure, the Hong Kong dollar is the most undervalued currency in the world relative to the dollar (47.7% undervalued), followed by Russia (43.6% undervalued).
Thailand has the most overvalued currency at +26.7%.
A currency is considered undervalued when its value in foreign exchange is less than it “should” be based on economic conditions.
However, currency value isn’t determined objectively, and may be undervalued due to a lack of demand, even if a country’s economy is strong.
Other factors are also taken into account, like investors’ appetite for risk, as we as the plethora of conditions (both locally and globally) that play into stability of a market.
In South Africa’s case, the local economy is in recession, while many political and policy issues make it a less desirable destination for foreign investment. Infrastructure failures, like load shedding,” also hinders developmental progress.