With only one week
left in the year, it is safe to conclude 2010 was an interesting year for the
financial markets. There was plenty to discuss and many concerns have yet to be
answered. The foreign exchange markets were not sheltered. Without doubt, I
assume 2011 will be just as exciting. As a foreign exchange professional, I am
often asked to make forecasts on my outlook. Because I have no crystal ball, I
often base my best guesses on factors that I think are important such as: supply
and demand, interest rates, risk aversion, gross domestic production, and other
economic data and trends. Some of my colleagues may even discuss a myriad of
technical tools for predicting currency movements, including trend lines,
Fibonacci levels and Bollinger Bands.
This week, as the year winds down
and the holidays approach, I thought it might be more interesting for the three
or four people who are in the office and actually have time to read this
article, to revisit an economic principle that is seldom discussed in the world
of foreign exchange: purchasing price parity (PPP). In its simplest terms, PPP
is based on the "law of one price." This theory states that in efficient
markets, identical services or goods should have the same price in different
markets. So, in theory, foreign exchange rates will adjust so the price of a
basket of goods in one country will equal the same price in another
country.
Let's look at a simple hypothetical example. If you were an
American in a foreign country and after a few simple calculations you realized
you just paid an equivalent of $20 for large, extra hot, triple shot, nonfat,
no-foam latte, with chocolate sprinkles in a double, you could only conclude one
of three things: you just got ripped off, the coffee quality is a much better
than the Yuban I normally brew every morning, or the local currency you are
spending is way overvalued. If it is a currency issue, the PPP theory might
conclude that over a period of time this currency should fall against the USD.
After all, one price means you should pay no more than a buck and a half for a
decent cup of coffee.
The Economist magazine has been publishing
its own version of a PPP theory since 1986. It is called the Big Mac Index. The
Big Mac was chosen because it is based on a well-known product and its prices
are easily tracked in over 120 countries. The production of this "basket of
goods" includes a wide range of costs, including various commodities, labor,
transportation, advertising and real estate. Since the McDonald's Big Mac is
essentially a standardized basket of goods and services, in theory, the foreign
exchange rates should make the Big Mac cost the same in Brazil, Russia, Thailand
or China as it is in the United States.
If not, the theory would indicate
a "valuation discrepancy." So, when we are comparing actual exchange rates with
PPP, we get an indication of which currencies are under or overvalued. Example:
If a Big Mac costs 14.50 CNY in Beijing and cost nearly $3.75 in San Jose,
California the one price theory, based on this basket of goods, concludes the
PPP exchange rate should be 3.87 CNY to one USD (14.50CNY/3.75 USD). The present
exchange rate is around 6.66 CNY to the USD. Thus, the CNY is 42 percent
undervalued against the USD. On the other hand, using the same theory, Swiss
franc is 75 percent overvalued. The Chilean peso, Canadian dollar and Japanese
yen are closer to equilibrium. (See chart for the latest) On another economic
principle, it should be noted that inflation in China is a growing concern. That
same Big Mac cost only 12 CNY only last year. The increase was part of
across-the-board price hikes blamed on rising wage and commodity prices. Last
year the CNY was over 50 percent overvalued.
Source: Bloomberg, SVB Financial
Group
(Click to view
larger version)
As you can imagine, many will find the Big Mac
index hard to digest. The critics are quick to point out the Big Mac is neither
a tradable commodity nor a product that can be easily shipped and still maintain
its quality. Additionally, local prices can also be distorted by taxes, property
rents, trade barriers, and the demand for hamburgers may be different among
various cultures. It is fair to say a Big Mac for a typical family in Thailand
probably does not have the same value as a McDonald's burger in my house. These
are all valid arguments.
The reality is that implementing the Big Mac
analysis or any PPP theory, as a forecasting model, may not work in the short
run, medium term, or ever. Trying to explain to the CFO that you think it is
prudent to liquidate the Swiss franc assets because your Big Mac in Zurich was
expensive, may not be the best idea. Remember, "Burgernomics" was created to
provide a simple and fun look into the world of macroeconomics and to make a
theoretical exchange rate theory a bit more appetizing.
Seasons
Greetings!
The views expressed in this column are solely
those of the author and do not reflect the views of SVB Financial Group,
or Silicon Valley Bank, or any of its affiliates. This material,
including without limitation the statistical information herein, is
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