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In 1986, the Economist came up with an interesting lighthearted interactive currency comparison tool called – The Big Mac index. Essentially, it measures the price of Big Mac across different countries and uses that as an indicator of currency valuation and whether a country’s currency value is “correct” or not. A little disclaimer here is that this is not a serious index, and merely gives a proxy of currency levels of countries relative to others.

Interestingly, on PPP basis Pakistan’s currency valuation, relative to the US, on the Big Mac index is moving in line with the inflation differential and nominal currency movement (with some variation). The index is updated every six months. When the nominal currency was clearly overvalued, the big Mac index was showing the same. In Jul-17, PKR was 21.5 percent overvalued based on PPP to the USD. In Jan-20, the overvaluation stood at 9.4 percent. The correction is 12.1 percent

The PKR depreciated by 31.9 percent between Jul-17 and Jan-20. The CPI index (new base) moved up by 21.8 percent in the same period. The CPI index in US moved up by 5.8 percent in that time. The inflation difference is 16.0 percent. Thus the real depreciation stood at 15.9 percent. The valuation based on PPP based big Mac index is corrected by 12.1 percent.

There is some gap between the actual and proxy; but the direction seems right and it gives a sense of what the currency levels are and which way the currency movement should be. During Jul-17 to July-18, the real depreciation of PKR was 11.8 percent and on Big Mac the overvaluation reduced by 14.8 percent. From Jul-18 to Jul-19, the respective movements were 15 percent and 9.7 percent.

The direction changed since Jul-19. The PKR appreciated and that is reflecting in Big Mac index too. The real currency appreciation stood at 7.1 percent between Jul-19 to Dec-19 (PKR depreciation: 2.7%; Pak-US inflation differential:4.4%), and the Big Mac index shows that currency is overvalued by 12.4 percent.  Yes, there are variation in actual and Big Mac data and it should not be taken too seriously. But it gives a sense of competitiveness of currency at a given point.

The point to emphasize is that there is a case of PKR over-valuation in the past six months. The nominal currency is appreciated while the inflation is in double digits. Big Mac is showing that PKR in Jan-20 is over-valued by 9.4 percent. For comparison to trading and competing economies, China is undervalued by 8.4 percent, India by 14.2 percent, Egypt by 15 percent and Turkey by 35.1 percent. This implies that overvaluation in Pakistan relative to India is 17.8 percent i.e. exporters in India are at 17.8 percent advantage to Pakistan. Foreign investors seeking to explore exporting markets have more chances to opt for India or other undervalued currencies.

Does this mean that PKR should be depreciated immediately to correct the imbalances? No, that would not be a prudent approach. The impact of currency depreciation between Dec17 to Jul19 is reflecting in CPI after a lag. The CPI peaked in Jul-Dec19 despite currency appreciation in the period.

The key challenge at this point for SBP is to manage inflation. Any further depreciation can bring more inflation and the currency over valuation could become higher. That could become a vicious circle. Exchange rate in Pakistan is now becoming market determined. The inflows in market are higher than out flows. The currency has a pressure of appreciation. SBP should (continue) to intervene and buy dollars from the market to build reserves. Once the inflation comes in single digit, then some currency could be adjusted, if required at that time.