What Are We To Do
By TAN SRI LIN SEE-YAN (THE STAR ONLINE)
Based on purchasing power parity, the ringgit is undervalued by 47%.
I am often asked: What is per capita PPP income. What does US$5,000 income @ PPP prices mean? Off-and-on, the term PPP intrudes into our lives: via TV news, newspapers and economic reports. PPP stands for purchasing power parity – a theory in economics first developed by Swedish economist Gustav Cassel after World War I. Simply put, this doctrine states that the exchange rate is determined by the relative purchasing power of any two currencies.
The common sense of this is that the same amount of money should purchase the same product in any two countries (whence, the term purchasing power parity). That is, the purchasing power of money, expressed in one currency, should change pari passu in different countries. If US$5 buys a cup of Starbucks coffee in New York and the actual cost of the same Starbucks coffee in KL is RM12, then the exchange rate should be US$1=RM2.40 according to PPP. But the actual exchange rate is close to RM3.60, or 33% cheaper.
PPP in today’s world
Is PPP relevant? To answer, we need to backtrack. During World War I, trade was disrupted between the allies and halted with enemies. When trade resumed after the war, a choice of new exchange rates was required. Any return to pre-war rates would not have made practical sense since countries had experienced significantly differing rates of inflation because of the disruption of war.
Let’s say before the war, US$1=30Ff (French franc). Since then, the price level in France had risen, say, 20 times and in the United States, doubled. Prices in France has thus risen 10 times more than in the United States; so the new exchange rate should be US$1=300Ff based on PPP (i.e. exchange rate determined by relative purchasing power of the two currencies).
Thus, PPP served as a useful guide at a time of major international turbulence. It was also practical to use and easy to understand. But it’s also too simplistic and even unrealistic. The world is not perfect. It’s also complicated. Many non-trading factors and too many other considerations do come into play in determining an exchange rate.
Today, the world has become even more imperfect and much more complex. Adjustment to stability (if ever) is far from instantaneous. Often, it involves a complicated web of geopolitical considerations which work to derail the timing of an often long process. Recent developments have led to widespread structural disruptions not seen since the 1930s. As a result, the market price discovery mechanisms we have taken so much for granted no longer function as a reliable guide for decision-making.
Exchange rates, interest rates, retail prices and the range of other price indices have become too “manipulated” to make good economic sense, in the face of an eco-system that has now become neither capitalist nor communist. It is in times like these that we look for simple, practical benchmarks that can offer sensible guides to help us manage the myriad of risks that just won’t go away.
The Big Mac index
In today’s globalised world, we encounter difficulties in assessing the value of currencies. Readers also ask: Is it true that the ringgit is undervalued? Why is the US dollar still so strong? How much basis-in-fact is there? The Economist magazine publishes annually its Big Mac index. The latest appeared in this week’s issue. It calls this index a “light-hearted guide to valuing currencies, provides some clues”.
Interestingly enough, it is based on the PPP theory and uses the Big Mac hamburger as the benchmark product since it is standardised and sold in more or less the same form worldwide. Comparison of the purchase price of this “common” burger in domestic currencies against the US dollar price would yield a PPP exchange rate between any currency and the US dollar. In this way, the rate of exchange that leaves the Big Mac costing the same in US dollars anywhere in the world provides a “fair value”, or PPP benchmark.
For example, you actually pay US$3.57 for a Big Mac in the United States; in the United Kingdom, it costs £2.29 or equivalent to US$3.69 converted at the current market exchange rate. The implied PPP exchange rate is therefore £1=US$1.56 compared with the actual market rate of £1=1.61. That’s close enough to fair value. But this is not always the case.
Value of the ringgit
Take Malaysia. According to this index, the Big Mac costs RM6.77 or only US$1.88 (converted at current market exchange rate) which is about half its price in the United States. This means that the ringgit has a much higher purchasing power in Malaysia than in the United States! Look at this another way: the implied PPP exchange rate is US$1=RM1.90. But the actual market exchange rate is closer to RM3.60. Nearly double!! Based on PPP, the ringgit is undervalued by 47%.
By the same token, the index showed that the Chinese renminbi is similarly undervalued, by 49%; Thai baht by 47%; Indonesia’s rupiah by 43%; Hong Kong dollar by 52%; Taiwan dollar by 37%; the Philippine peso by 25%; and the Singapore dollar by 19%. It would appear that the currencies of China and Hong Kong and those of most emerging Asean economies are significantly undervalued by 40%–50% against the US dollar.
At the other spectrum, most major European currencies appear substantially overvalued vis-a-vis the US dollar: the euro by 29%, Swiss franc by 68% and Scandinavian currencies by 40%–70%. However, like the pound sterling, the Japanese yen and Australian dollar are close enough to the fair value on this basis. These are interesting comparative numbers.
Malaysia’s 2008 per capita income (at current market prices) was placed at US$7,738. On a PPP basis, the international Monetary Fund (IMF) estimated this income’s purchasing power to be in the region of US$14,000. A word of caution, however. The PPP is subject to many flaws. Indeed, many economists regard it as quite irrelevant these days. Why is this so?
PPP as a guide
For one thing, costing of the burger includes many local inputs (e.g. wages, rent, advertising, etc.) which tend to be lowest in the poorest countries. Perhaps, that is why the Big Mac is so overpriced in Europe. Worse, the outcome will be different for different single standardised products used.
To be really helpful, we will need a representative basket of goods and services (not just the Big Mac alone). Price indices, however, include many goods and services that do not enter into international trade. Moreover, the jury is still out on whether the exchange rate moves in response to price changes or the other way around. The causal relationship is very unclear.
The PPP works from a base rate, the legitimacy of which can be in doubt. Most important, it overlooks the often volatile supply and demand of foreign exchange arising from non-trade sources: long and short-term foreign investment, loan flows, transfers and other speculative movements of capital. Finally, in our imperfect world, government interventions (e.g. exchange control, trade restrictions and taxes) do affect the purchasing power of currencies.
Nevertheless, PPP remains in use simply because it is readily understood, has an unusually simple construct, and is very transparent. It appears to be more useful during periods of marked changes (especially in rates of inflation). Also, it acts as better guides to exchange rate misalignments among nations with similar levels of income.
Be that as it may, the latest Big Mac index points to interesting trends: major European currencies appear grossly overvalued vis-a-vis the US dollar, and many Asian currencies, overly undervalued. Or is it that the base currency – the US dollar - is way overvalued?
You can’t tell from the PPP exchange rates. Nevertheless, the theory can serve as a crude approximation. But, it cannot offer a satisfactory explanation of today’s exchange rates. Prof Gottfried von Haberler, my mentor at Harvard and a guru on exchange rates, used to say: After all, in the final analysis, people value currencies for what they will buy.
The Japanese lesson
In Asia, the Chinese renminbi is often singled out to be grossly undervalued (the PPP also shows this). Strong pressures to re-value have come from the United States and the IMF. However, these have eased with the recent global meltdown. The Japanese experience over three decades ago offers a valuable lesson in history.
From the 1980s into the mid-1990s, Japan bashing was in vogue in the United States, much as China bashing was in the Bush years. Back then, Japan’s large bilateral trade surplus led to the United States continually threatening it with trade sanctions. Consequently, “voluntary” export restrains were put into place and the yen was allowed to appreciate. It did so all the way from US$1=360 yen in 1971 to touch 80 yen in April 1985.
This unhinged the Japanese financial system and induced the bubble in stock and land prices in the late 1980s which eventually collapsed in 1991. This resulted in Japan’s unrelenting deflationary slump of the 1990s – known now as the “lost” decade. Japan has yet to fully recover and remains today in a zero interest liquidity trap.
The Bank of Japan has failed to re-ignite economic growth. The recent financial meltdown and global recession have not made matters any better. Yet, Japan’s trade surplus as a share of gross national product (GNP) has not been reduced in any significant way.
Of course, the world has since changed dramatically. Nonetheless, in my view, any renewed pressures to force a revaluation of the renminbi at this time will run the risk of: (i) possibly sending China into a similar deflationary slump that hit Japan during the 1990s; and (ii) destabilising its currency to the detriment of global growth recovery.
The state of the world economy remains delicate. It calls for prudence. In the final analysis, I don’t see how the US trade deficit can be bridged by simply revaluing China’s exchange rate. The key must lie in increased US national savings. This won’t be easy given the current weak US economy.
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