Wednesday, October 03, 2007

A More Realistic PPP for Australia

PPP means purchasing power parity. At least that's what it means in economics. There are the regular market based exchange rates between currencies and then there are theoretical exchange rates which if we could buy and sell foreign currency at those rates rather than the actual rates a given basket of goods would cost the same real amount of money in every country. Anyone with international experience knows that things are very expensive in Switzerland and very cheap in China or India. This means that the Swiss Franc, Yuan, and Rupee do not trade at PPP exchange rates to the US Dollar. If they did, things would cost the same amount of US Dollars in each of the three countries.

Researchers at the University of Pennsylvania pioneered the estimation of PPP exchange rates and further work has been done by the World Bank and others. This research involves collecting the prices of a large basket of goods and services. The Economist magazine pioneered a very simple alternative - recording the price of a Big Mac hamburger in each country. The difference between the price in USD at existing exchange rates and the price of a Big Mac in the US indcates whether a currency is over or undervalued. According to the February 1st edition of the index a big Mac costs $US3.22 in the US and $A3.45 in Australia. This implies a PPP exchange rate of 93 US cents per Australian Dollar. As the Australian Dollar is trading at 88 US cents, it is still undervalued. Though services are cheap in Australia, goods are generally more expensive. A more realistic indicator might be the price of a coffee at Starbucks. A grande coffee of the week costs $A2.75 and the "coffee of the day" cost $US1.75 last time I checked though it could be higher in expensive locations like NYC or airports. But this exchange rate is just 64 US cents, making the Aussie Dollar wildly overvalued. Other drinks on the Starbucks menu seem to have similar implied exchange rates.

It is difficult to see how the US dollar could "collapse" in the long-term in the face of these kind of facts. Australia is probably not expensive when compared to most northwest European countries. In the short-term currencies are more driven by interest rate differentials. In the long-term PPP eventually has some effect though richer economies' currencies tend to remain overvalued relative to poorer countries' currencies.

3 comments: said...

With inflation averaging around 2.5%pa over the past decade in Australia, the price of Big Macs and Starbucks has hardly changed over this time period. Yet the A$ has gone from around 75c US down to below 50c US, and now back towards 90c US. Seems that there is not a strong relationship between exchange rates and PPP. With the $A being boosted by relatively high interest rates and strong commodity prices, and no federal deficit, it seems further gains against the USD are possible. We could even get back to parity with the USD or above, which is where the AUD was when it first floated.

I really think that the USD has started to see the beginning of a prolonged slide. I think the accumulation of USD by China and Japan helped support the USD despite the increasing US federal deficit and long-term problems with social security. Once the USD starts to slide it and US interest rates drop it becomes much less attractive to foreigners, so they may well start to off load their holdings in USD.

ML said...

LoL, The Economist had once ran a Starbucks Latte index (exactly the same idea you had) which showed the Yuan to be OVERVALUED. It was never mentioned again.

They have always cautioned against a blanket application of the PPP, because many components of the cost (i.e. labor) are not tradable. That said, I agree that USD needs to appreciate against Asian currencies. I also don't see it to go much lower against the EUR or the pound. So $USD may rebound even as the trade-weighted dollar index further weakens.

mOOm said...

Yes I was aware of the Latte Index. But as you say they only did it once. I think you must mean that the USD shoudl depreciate against Asian currencies and appreciate against the Pound, Euro, Swiss Franc etc. The AUD is not so out of whack. When you consider the cost of services (though mostly nontradeable) it coudl be fairly valued.