The Economist
LAST summer mere talk from the Federal Reserve about "tapering" (ie, phasing out) its monetary stimulus through asset purchases was enough to fry emerging-market currencies. The exchange rates of the "fragile five"--Brazil, India, Indonesia, South Africa and Turkey--fell sharply. Now that tapering has, belatedly, commenced this month, which currencies look susceptible to further grilling?
The Big Mac index, The Economist's gauge of exchange rates, offers some food for thought. The index is based on the theory of purchasing-power parity (PPP), which holds that currencies should in the long run adjust to rates that would make a basket of goods and services cost the same wherever they were bought. Our basket contains just one item, a Big Mac, since its ingredients are the same the world over, except in India, where the Maharaja Mac is made of chicken. Because buying a Big Mac in Norway, for instance, costs $7.80 at market exchange rates compared with $4.62 in America, our index suggests that the Norwegian krone is almost 70% overvalued.
Of the fragile five, Brazil looks the most vulnerable, because a Big Mac there costs $5.25, implying that the real is overheated by 13%. The other four all have undervalued currencies, to varying degrees. The Indonesian rupiah, the South African rand and the Indian rupee are undercooked by 50% or more.
In the short term, however, it is financial and economic factors, together with confidence or lack of it, that hold sway in currency markets. Brazil is running a current-account deficit of 3% of GDP, but it has a healthy stockpile of foreign-exchange reserves to call upon if necessary. Though the credibility of the Brazilian government has been eroded, the central bank has clawed back some respect by pushing through interest-rate rises.
In contrast, both Turkey and South Africa are running current-account deficits (as shares of their GDP) that are twice as large as Brazil's. Their foreign-exchange reserves are much smaller than Brazil's when gauged against their external-financing requirements. The Turkish lira, which has been plummeting in recent days, has also been affected by the central bank's stubborn refusal to raise interest rates, along with a more general loss of confidence in the Turkish government. The lira has been among the worst performers of the currencies in our index over the past year; as a result, it has swung from 9% overvalued to 19% undervalued.
Although new forecasts from the International Monetary Fund (IMF) this week envisage an increase in global growth from 3% in 2013 to 3.7% in 2014, the demand for commodities is likely to remain restrained. That has already been affecting the currencies of economies that are rich in resources, such as Australia and Canada. Declines in the Australian dollar since it peaked in 2011 mean that it is now undervalued, by 3% according to our index. By contrast the Canadian dollar, which has been dropping sharply in recent weeks, remains overvalued, by 8%.
The IMF is predicting growth for the euro area of just 1% this year. That forecast chimes with the message from the Big Mac index, which finds that the single currency is overvalued, by 7%. The strength of the euro is unwelcome for exporters and casts a shadow over a recovery in the 18-country zone that is already proving to be feeble and faltering. By contrast the British pound is at the right level, according to the index, which should help the much sturdier growth the IMF now expects in Britain this year, of 2.4%.
Our Big Mac index will soon be beefed up with the addition of the Vietnamese dong as McDonald's is soon to open its first branch in Vietnam, the first new country to welcome the golden arches in 15 years. Ketchup on this new entry to our index online next month.
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