The mid-year 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 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 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
The Big Mac Index measures the real value of currencies using two methods – the latest of which was introduced in 2018.
The first measure is the ‘raw’ index, which looks at the direct prices of a Big Mac in different countries.
In this measure, a Big Mac costs R31.00 in South Africa and US$5.74 in the United States, meaning the implied exchange rate is R5.40.
The difference between this and the actual exchange rate, R14.18, suggests the South African rand is 61.9% undervalued, The Economist said. This is more undervalued than at the start of the year.
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 – which factors in another important indicator – GDP per capita – to draw a more ‘real world’ conclusion.
In this index, South Africa’s currency still remains heavily undervalued, but less so than when dealing with the straight conversion data.
A Big Mac costs 62% less in South Africa (US$2.19) than in the United States (US$5.74) at market exchange rates.
Based on differences in GDP per person, a Big Mac should cost 41% less. This suggests the rand is 35.2% undervalued, The Economist said, which means its ‘real’ value should be closer to R9.18 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.
The rand has taken some pain over the last year as local policy uncertainty, slow economic growth, high levels of debt and a host of international factors chipped away at its value.
In recent weeks, the rand has rallied and regained some of its strength, as talk of a new rescue plan for power utility Eskom made headlines, while news out of international markets, particularly the US, restored appetite for risk among investors.
According to Bianca Botes, Treasury Partner at Peregrine Treasury Solutions, next week’s sitting of the Monetary Policy Committee is also highly likely to reduce local interest rates, but the impact on the rand will probably be overshadowed by the positive effect of the expected Fed rate cut, and the expected benefits to the SA economy.
“The local economy, however, will require more than an interest rate cut to see any significant and sustainable growth,” she said, adding that underlying strength may be tested by an interest rate cut
“With the current momentum the rand is likely to test the R13.80 mark, while local interest rate cuts can see the rand trade to the upper band of R14.15 provided that the global backdrop remains the same.”
By 09h45 on Friday morning, this is how the rand was trading against major currencies:
- ZAR / USD: R13.90
- ZAR / GBP: R17.44
- ZAR / EUR: R15.67