MarketVVizard's Market Thoughts: Burgers or beans? purchasing-power parity

» MarketVVizard - Burgers or beans? purchasing-power parity

[Thanks for posting the Roundtable Jen]
______________________________________________
Starbucks index

Burgers or beans?

Jan 15th 2004 From The Economist

A new theory is percolating through the foreign-exchange markets

STARBUCKS was due to open its first coffee shop in France on January 16th-a brave step, given that Paris invented café culture. Some of the French press are frothing at the mouth at the notion that Americans think they can make coffee. Jean-Paul Sartre, they scoff, would hardly have found the same inspiration slurping from a paper cup as sipping black coffee in Les Deux Magots. The Economist, however, has been pondering a more existential idea: what can the price of Starbucks coffee-now served in as many as 32 countries-tell us about exchange rates?

Readers may be familiar with The Economist's long-running Big Mac index: by comparing burger prices around the world, it offers a light-hearted guide to whether currencies are at their "correct" level against the dollar. Given the dollar's recent plunge against the euro and growing complaints that China is unfairly holding down its currency, we cannot resist testing whether a Starbucks "tall latte index" reaches the same conclusions as our Big Mac index. Both are based on the theory of purchasing-power parity (PPP). This says that, in the long run, exchange rates should move towards levels that equalise the prices of a basket of goods and services in different countries-ie, a dollar should buy the same everywhere.

By coincidence, the average price of a Starbucks tall latte in America is the same as the average price of a Big Mac, $2.80. By dividing the local currency price in each country by the dollar price we can calculate dollar PPPs. Comparing these with actual exchange rates is one test of whether a currency is undervalued or overvalued.

Our tall-latte index tells broadly the same story as the Big Mac index for most main currencies (see table; see article). Economic trouble is surely brewing in Europe: the euro (based on the average price of $2.93-$3.70-in member countries where Starbucks operates) is about 30% overvalued against the dollar. Sterling is 17% too strong. By both measures, the Swiss franc is the world's most overvalued currency. The Canadian, Australian and New Zealand dollars are still undervalued against the dollar despite their recent climb.

Where the two measures differ is in Asia. The burger index says the yen is 12% undervalued against the dollar; on the coffee standard, however, it is 13% overvalued. More startling is the Chinese yuan: it is 56% undervalued according to the Big Mac, but spot on its dollar PPP according to our Starbucks index. If so, American manufacturers have no grounds to complain about the yuan. The pricing differences probably reflect different competition in the markets for the two products.

Many readers will find burgernomics and lattenomics hard to swallow. Both are flawed as measures of PPP, because they are distorted by differences in the cost of non-tradables such as rents. Yet they are surely a more fun way to understand exchange rates than textbooks. Many readers ask why we don't we use the price of The Economist around the globe. Unlike the Big Mac or a tall latte, The Economist is not produced locally in lots of countries, so distribution accounts for a large chunk of its cost. Burgers and coffee are therefore likelier to give some clues about currencies.

-----------------------------------------------------

The Big Mac index

Jan 15th 2004 From The Economist print edition

The Economist's Big Mac index is based on the theory of "purchasing- power parity". Under PPP, exchange rates should adjust to equalise the prices of a basket of goods and services across countries. Our basket is the Big Mac. For example, the cheapest burger is in China, at $1.23, compared with an average American price of $2.80. This implies the yuan is 56% undervalued. Relative to its Big Mac PPP the euro is 24% overvalued against the dollar. In contrast, the yen is 12% undervalued.

-- posted by MarketVVizard