The latest update to The Economists’ Big Mac Index for 2019 shows that the South African rand is still greatly undervalued.
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 2019
The Big Mac Index measures the real value of currencies using two methods – the latest of which was introduced in 2018.
Using the raw data, a Big Mac costs R31.00 in South Africa and US$5.58 in the United States. The implied exchange rate is R5.56 to the dollar.
The difference between this and the actual exchange rate, R13.87, suggests the South African rand is undervalued by 59.9%.
However, 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 has also included an ‘adjusted price’ index in its July update – which factors in another important indicator, GDP per capita, to draw a better conclusion.
In this index, South Africa’s currency still remains heavily undervalued, but less so than when dealing with the straight conversion data.
In PPP terms, a Big Mac costs 60% less in South Africa (US$2.24) than in the United States (US$5.58) at market exchange rates. Based on differences in GDP per person, a Big Mac should cost 45% less. This suggests the rand is 26.9% undervalued, and should be at R10.14 to the dollar.
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, we have stagnating economic growth and many political and policy issues that make it a more undesirable destination for foreign investment.
According to analysis by Peregrine Treasury Solutions, the rand could get to its fair trade levels of around R10, but only if global and local politics aligned into the perfect conditions for South Africa to hit the growth it needs.