“Burgernomics” for South Africans
In 1986, journalists writing for the Economist devised a novel guide to help determine whether currencies are at their correct level. They based this guide on a standardised product available in over 100 countries the McDonalds Big Mac burger. They chose the Big Mac because it is a highly uniform product available everywhere at the same quality. What started as an interesting and light-hearted guide to currency valuation has since turned into the widely acclaimed Big Mac Index (BMI). As the Economist put it back in 1989, [The BMI] seeks to make exchange rate theory a bit more digestible.
Whats interesting about the BMI is that it provides a quick reference as to what a currency would buy in another country. Since prices in poor countries tend to be lower, for example, an American spending his dollars in South Africa will get a lot more for his money than he will back home. Similarly, the average haircut in the US is far more expensive than in South Africa. This is true for the majority of non-tradable goods and services in developing countries. It is therefore misleading to convert South African wages into dollars at market exchange rates. This holds some major implications for the way in which we view the growth of developing countries. For instance, converting a developing countrys GDP into dollars at market exchange rates will significantly understate the true size of its economy and its living standards.
But how do we know how much more a dollar will be worth in a country like South Africa? For this we need a better method than simply converting outputs at current exchange rates. A better method, known as purchasing power parity (PPP), takes into account price differences across economies. PPP tells us that although the size of your pay cheque is important, its purchasing power is perhaps more so. For example, a Big Mac burger costs $3.57 in the US and R17.95 in South Africa. However, at the current exchange rate ($1=R7.39) a Big Mac should cost about $2.43 (R17.95/R7.39). Given that the Big Mac price in the US is $3.57, the implied purchasing power parity of the dollar is R5.03 (R17.95/$3.57). But the current exchange rate is R7.39, suggesting that the Rand is undervalued by about 32%. If you do the same calculations for most other developing countries you will find that their currencies are also undervalued. China, Sri Lanka and the Ukraine have the most undervalued currencies relative to the dollar at 49%. At the other end of the scale is Norway with the most overvalued currency at 72%.
An interesting corollary to the BMI is how long it takes a worker to buy a Big Mac burger in their respective cities. A report produced by UBS entitled Prices and Earnings showed that the world average is 37 minutes in order to earn enough to pay for a Big Mac. However, in Johannesburg it takes an average of 26 minutes. In Chicago (USA) it takes 12 minutes, in Beijing (China) 44 minutes and in Nairobi (Kenya) it takes over 2 hours.
People see development in developing economies as buildings being erected, roads being built, and new advances being made in telecommunications. When converted at market exchange rates developing countries contribute relatively little to total global output. Take China for instance, over the past 20-odd years of reform and opening up, China has experienced sustained, rapid economic growth, with an average annual growth rate of GDP in the 1990-2008 period of approximately 10 per cent. When converted at market exchange rates, China ranks sixth on the global economic rankings. However, when converted using the PPP method, China jumps to second place, ahead of Germany, the UK and France and accounts for roughly 13 per cent of world output. India moves from eleventh to fourth place, and Brazil, Russia and South Korea are ahead of Canada. Interestingly South Africa moves from 33rd to 21st, ahead of Switzerland and Sweden.
Another major negative implication of simply converting outputs using market exchange rates is that inequality figures are exaggerated. Using market exchange rates, the average American is 33 times richer than the average Chinese; but on a PPP basis he is only seven times richer. This apparent magical decline in inequality is not surprising when one considers that along with rapid economic development, Chinas population living in extreme poverty (defined as living on less than 1 US dollar a day) has decreased by at least 150 million, accounting for 85 per cent of the total poverty reduction in the East Asian region.
Of course the Big Mac Index remains a light-hearted approach to exchange rates evaluation but it provides an easily digestible idea of what is happening on the ground in developing countries. Developing countries are not only growing much faster than rich countries, they are also demanding an increasing quantity of resources in order to do so. This is what has been driving the phenomenal increase in commodity prices in recent times despite the modest growth of developed countries.
Author: Jasson Urbach is an economist with the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the authors and are not necessarily shared by the members of the Foundation.
FMF Feature Article/ 22 December 2009
Jasson Urbach is an Economist and director of the Free Market Foundation.
Publish date: 22 December 2009
The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.