The acronym ‘PPP’, or its fuller version ‘Purchasing Power Parity’, gets a mention in my earlier article, in which I mention that it (i.e. PPP) is one of the ways of determining a currency’s long term [exchange rate] value. So what exactly is PPP? I am sure you will find many formal definitions by doing a web search, my intention here is to explain its meaning in simple terms.
PPP is one of many ways of deriving a currency’s value, in terms of whether it is overvalued or undervalued, by comparing the cost of chosen product(s) in two currencies. The idea is to choose a product (goods or services) that is mainly locally produced and has no known tax skews; for example, alcohol or cigarettes are not good choices as they are heavily taxed in some countries (even illegal in some), while hardly taxed in other countries.
A chosen product should mainly reflect the local costs (labour, producing, marketing etc) against a backdrop of stable demand. Economists keep coming up with many such examples of ‘ideal’ products, one particular example I like is the Economists “Big Mac” index. Here the idea is that a Big Mac hamburger can be produced and sold locally and since it is a food item, not many taxation regimes explicitly go after it. If a price of the Big Mac is permanently higher in one country compared to the other, then at some point arbitrage would occur: i.e. people will start profiting from taking cheaper produced Macs and selling where they get more money, hence in the long run a levelling of prices will occur. So it is not possible to have a permanently established asymmetry in prices and therefore the PPP concept is widely used as a measure of a currency’s intrinsic value.
Looking at data from the last available Big Mac index from July 2010 (Ref: http://www.oanda.com/currency/big-mac-index), we can see that a hamburger in China costs (on average) 13.2 Yuan, while in USA it costs 3.73 Usds. So if we take the ratio; [hamburger in China] / [hamburger in USA] , the we should get the currency value of Yuan/Usd (13.2 / 3.73) = 3.53 . At present (as at 16th Sept 2010) we see that the value of Yuan/Usd is 6.7 . This is what makes those in charge of US trades - US Treasury Secretary and the likes – angry. With a 52% undervalued currency and being a major trading partner to the US, China is coming under pressure to revalue its currency. There are many interesting examples and skews one can point to, e.g. the Norwegian Krona’s is nearly overvalued by two times when compared to the dollar.
One further example I would like to bring out is the Japanese Yen. Those who follow the Forex markets and news will no doubt know that Bank of Japan, BoJ carried out a currency intervention to weaken the Yen (on 14th Sept ’10) versus the Usd from a rate at the time of Usd/Jpy ~ 83 to 85.5. If we go by the PPP index, then the Yen’s nominal value versus the Usd should be, according to the Big Mac index, around 320/3.73 = 85.8 . Looking at it from this valuation perspective, a value of 83 hardly seems like a point that needs BoJ to intervene. So why did the BoJ intervene? I knew that the action was imminent, though due to lack of friends at BoJ, I did not know the precise timing.
If you look at the chart below, showing the Yen’s range versus the Usd, you can see why they (BoJ) were getting nervous. The two charts below show Yen valuation pre-intervention.
If the Yen’s value had broken the ~ 82 level on the left of the top plot and had constantly stayed below that level for sometime, then potentially there would be a loss of confidence in the Usd/Yen valuation – investors would pile on buying the Yen as they leave all historical benchmarks behind. Yen’s strongest valuation was around the 80 Yen mark in April 1995.
The situation at present, despite being just 2.5 Yen above the recent minimum, seems to be more comfortable (see the two plots below and compare the position of the red line). Although ideally many in Japan would be more comfortable with Yen values hovering between 90 to 95.
Source | The Currency Forecasting Blog (CFB) | http://currency-forecasting.blogspot.com/2010/09/purchasing-power-parity-ppp-versus.html
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