Wednesday, January 18, 2012

A dollar at Rs 32? Big Mac says so, but don’t count on it..........

By R Jagannathan

If The Economist is to be believed, the India rupee is the most undervalued currency in the world. If that’s the case, why are foreigners avoiding it like the plague? Either the index is wrong or the foreigners don’t know what they are doing.
In its latest version of the Big Mac Index, a spurious index based on the price of a McDonald’s Big Mac in various countries, the rupee is 61 percent undervalued since Big Macs (or the Indian equivalent, since they don’t sell the real Big Mac here) cost that much less here.
If this undervaluation figure is right, the rupee should be quoted realistically around Rs 32 right now when it is actually at Rs 51 to the US dollar.
The Big Mac index is based on the concept of purchasing power parity (PPP) – the purchase cost of the same item in different countries. If a given loaf of bread costs 25 cents in India and $2 in the US, a $1 income in India is worth $8 in the US, assuming one only has to buy bread.

In the Big Mac Index, a spurious index based on the price of a McDonald’s Big Mac in various countries, the rupee is 61 percent undervalued. AFP
The Economist carries this PPP analogy and uses the price of the Big Mac in various countries to check if currencies are undervalued or overvalued. Thus, if an item costs $10 in the US, and $5 in China and $1 in India, the Chinese currency is undervalued by 50 percent and the Indian one by 90 percent.
In the latest computation of the Big Mac Index published by The Economist, the Big Mac costs $4.2 in the US and $1.62 in India – making the latter 61.5 percent cheaper than the US. Ergo: the rupee is undervalued to the same extent.
Similarly, the Chinese Big Mac is worth $2.44, which is 42 percent lower than the US price. So, by definition, US trade warriors feel vindicated in their belief that China is using a weak yuan policy to export to the US.
The Swiss franc is the most overvalued currency, since the Big Mac costs $6.81 in Switzerland. That’s 62 percent overvaluation. India’s black money wizards should avoid eating too many Big Macs in Switzerland when they are depositing their ill-gotten wealth in that country.
But the Big Mac Index has come under serious criticism from economists who say that the raw PPP index needs to be at least adjusted for relative costs. When labour costs in China and India are so much below American costs, prices will reflect this reality.
In the 30 July edition, therefore, The Economist adjusted raw Big Mac prices with the country’s per capita income, and came up with completely different interpretations.
Once deflated by lower average country incomes, the Big Mac Index shows more realistic currency values. Thus, against an undervaluation of 53 percent in July this year, the adjusted index for India showed a rupee undervaluation of only 8 percent.
On 30 July, the Big Mac (which is chicken based in India against beef elsewhere) cost Rs 84 ($1.89 in terms of the dollar values then). Today, after the rupee depreciation, it is $1.62.
Since July, the rupee has actually depreciated by another 15-20 percent in nominal terms. This means the gross undervaluation must be in the region of 20-25 percent.
However, this does not tally well with the Reserve Bank’s real effective exchange rate (REER) for the rupee – a measure of how exchange rates have moved against a basket of currencies weighted by trade and adjusted for relative inflation.
Given how the rupee has moved against the US dollar and other currencies, and also given our higher rate of inflation, the Reserve Bank says that the rupee’s REER is now just 3.13 percent more (as of December 2011) than what it was in 2004-05. This means the rupee has appreciated by this small percentage in REER terms in the last seven years in real terms.
The Big Mac Index would suggest that the rupee need to appreciate another 20-25 percent to reach its ideal value.
The bottomline is this: there is no real value that one can safely assign to any currency. While fundamentals like inflation and trade deficits matter – capital flows can make all the difference.
The rupee’s real value is what the market is willing to pay for it at any point of time. As we noted recently, it will have a rough ride, never mind what the Big Mac says.

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My Commnets:

After reading the above article, I can say that Rupee is hammered or let battered delibaretly for reason best known to RBI and Politicians.
Even though the auther says don't count on it,still Rupee needs to appreciate by 25%  and that is around 40 against dollar.

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