Understanding the theory of purchasing power parity

In an era of sophisticated technology, where oceans and mountains no longer provide a barrier to trade, it is easy to understand why economies across the world are tightly intertwined and dependant in terms of trade. The fact that we no longer have fixed exchange rates (as under the old classical gold standard) between countries means it is possible for one country’s currency to become under or over valued in relation to another. This is an important factor to consider with respect to international trade and finance, as it has a direct impact on the sustainability of a country’s economic growth rate and global competitiveness.

There has been much concern and debate around the rand’s strength in recent months, but how many actually understand how people in the economic and financial arena actually come to this conclusion. One of the simplest theories that can be used to explain currency valuation is known as purchasing power parity (PPP). This concept is founded on the “law of one price,” which essentially means that identical goods in 2 different countries have the same price when expressed in the same currency. The reason for this is that due to free competition, prices will equalise as consumers shift their purchases to markets (or countries) where prices are lowest.

An easy and informal way to explain how PPP works is the application of the Big Mac Index created and made famous by the Economist[1]. As one can find McDonalds food franchises in almost every major economy, it is relatively easy to track the final price of its products. The Big Mac PPP Index uses the price of a single Big Mac burger in two countries (in their own currencies) as the basket in question to evaluate the strength / weakness of the one country’s currency relative to the other. This is done by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency). This value is then compared to the current spot exchange rate. If the value is lower it implies that the currency of the first country is undervalued (the actual exchange rate is more than what it should be); if it is greater, it implies the currency is overvalued. In October 2010 the average price of a Big Mac burger in the USA was $3.71[2], while the cost of the same burger in South Africa in rand terms averaged R19.99. Applying the above formula implied a PPP exchange rate of 5.39 R/USD. During October 2010 the average exchange rate was 6.90 R/USD. According to the Big Mac Index (based on the idea of PPP), the rand in October 2010 was undervalued by approximately 27%.

At this point one may wonder why many investment managers are saying that the rand is and continues to be overvalued at a current exchange rate of 6.73 R/USD (26 April 2011), if the Big Mac PPP index states otherwise. Quite simply, the Big Mac Index is an oversimplification of PPP theory and in essence has just been used in this article to illustrate the principle behind PPP. In addition and as with any other economic theory, the application of PPP is not as simple as it appears to be. Over the years, if not decades, there have been many debates and much academic research done on testing the validity and soundness of this theory. Despite it having many methodological issues in terms of, for example, the selection of a comparable basket of goods and services to compare purchasing power across different countries, it also does not take into account transport costs or differential taxes and tariffs between two countries. It also can realistically only take into account the cost of goods and services that are trade-able. As with the Big Mac example, costs that cannot be accounted for in the price of the burger could include variations in wages, electricity, productivity etc.

The theory itself is however useful in certain estimations. It can be used to determine why exchange rates move in a certain way. Under normal circumstances, countries with a high level of inflation will generally have depreciating currencies, while countries with low inflation will have appreciating currencies. PPP can also be used as a mechanism to gauge the competitiveness of global prices. If a domestic country’s currency depreciates relative to another, the country generally becomes more competitive as the prices of its goods and services become cheaper and vice versa should its currency appreciate.

One of the most useful and interesting applications of the PPP theory is when governments intervene to manipulate the official exchange rate of their countries in order to affect the strength of their currency and also then international trade. In such a situation applying PPP theory gives one a better idea of what the real exchange rate of the currency should be.

The PPP theory is also actively used by organizations, such as the International Monetary Fund (IMF) and the World Bank. The IMF uses this calculation to devalue currencies, while the World Bank uses it to do an international comparison of GDP size and per capita GDP.

PPP is an economic theory that is certainty not flawless, as the value of a country’s currency is directly related to many other factors, like geo-political issues, socio-economic issues, government intervention and other variables that cannot always be quantified. So while it may not be an exact science, the theory of purchasing power parity does enable us to compare currencies in a more basic direct method and give us an idea of what the real or relative value of international currencies could be.

1 http://www.economist.com/markets/Bigmac/Index.cfm

2 http://www.oanda.com/currency/big-mac-index