# FX Theory: Purchasing Power Parity

In this chapter we explain the Purchasing Power Parity, in particular the most relevant version of it, the PPP based on producer price indices (PPP-PPI), the one that reflects productivity of local firms. It is shown that the commodity currencies, AUD, NZD and NOK were strongly overvalued in September 2012 but the Swiss franc was not.

## The theoretical basis

In this section we show the theoretical basis like tradable goods, the law of one price, the Penn and the Balassa-Samuelson effect.

### Law of one price

This law requests that in an efficient market, all identical goods must have only one price.

### The “Penn Effect” effect

Tradable goods cannot have large price variations between locations as buyers can obtain them form the location with the lowest price. But the majority of services must be delivered at the local level. Also many goods that have been manufactured have high costs associated with transport. The Penn Effect most often happens in the same direction: high incomes mean the average price will generally be high.

This implies that in order to compare the fair value of currencies only tradable goods should be considered.

### The Balassa–Samuelson effect

This economic model assumes that productivity or productivity growth-rates will differ more in a country’s traded good’s sectors that other sectors (Balassa-Samuelson hypothesis).

This implies that:

• Workers in some countries generate greater productivity than those in other countries and this acts as the source of income differences.
• For some labor-intensive jobs productivity innovations will have smaller effects. No matter their education or location a burger flipper will manage the same number of burgers/hour.
• Fixed-productivity sectors produce goods that cannot be transported (e.g. haircuts, the hairdresser has to be able to physically touch the hair to cut it).
• For local wages to be equalized the same job might be worth more in one location than another
• The CPI contains local goods (will be more expensive in rich countries) and tradables (same price in all countries).
• PPP (purchasing power parity) is used to peg the exchange rate for tradable goods (this is testable). See the law of one price above.
• Money exchange rates vary related to productivity of tradable goods (more than average productivity); and, for real goods the differential is less than for money.
• Productivity becomes income, meaning real income is not affected by changes in money as much.
• This is like stating that real income can be exaggerated by money exchange rates. Alternatively, items will cost more in richer countries.

For other theories why productivity plays a strong role in valuing currencies see our page on theories of the comparative advantage in international trade and the Neo Factor Proportion Theory.

## Absolute purchasing power parity measures

Absolute measurements compare a product like the Big Mac, which is nearly equal everywhere, and its price among different countries. Various Swiss export organizations continue to use these values in order to claim that the franc is overvalued. According to the Balassa–Samuelson effect they must compare tradable goods. A Big Mac produced in Switzerland cannot be sold in another country.

### Big Mac and Starbucks Tall Latte

CountryStarbucks tall latte indexMcDonald's Big Mac Index
Australia-4-17
United Kingdom+17+23
China-1-56
Eurozone+33+24
Hong Kong+15-45
Japan+13-12
Malaysia-25-53
Mexico-15-21
New Zealand-12-4
Singapore+2-31
South Korea+60
Switzerland+62+82
Taiwan-5-21
Thailand-31-46
Turkey+6+5

Source Wikiwealth

Certain countries like Switzerland use import quotas and taxes for meat or milk in order to protect local farmers. These measurements do not make sense as food prices do not say nearly anything about the competiveness of an economy.

### Absolute PPP via  OECD

The OECD statistics are based on one common goods and services consumer price basket, e.g. the category “food” has the same weight in all countries. Therefore these weights differ from the ones in the real consumer price index of the concerned countries, in the Chinese CPI food has higher relevance, but in Switzerland less.

CountryPrice level (USA = 100)CountryPrice level (USA = 100)
Australia157Korea80
Austria111Luxembourg124
Belgium117Mexico64
Chile73New Zealand126
Czech Republic80Norway160
Denmark149Poland59
Estonia84Portugal99
Finland127Slovak Republic76
France115Slovenia90
Germany107Spain103
Greece100Sweden128
Hungary70Switzerland174
Iceland118Turkey56
Ireland125United Kingdom132
Israel117United States100
Italy99
Japan149

source: [OECD August 2, 2012]

### Differences in CPI baskets

China .Italy .Switzerland .Germany .EU .US since 2008US before 2008Sweden .Japan .
01 Food, non-alc 31.8%17.15%10.30%10.36%15.30%7.82%7.66%13.90%25.25%
02 Alcohol, tobacco3.5%3.06%1.76%3.90%3.95%1.96%1.90%4.00%(incl. in food)
03 Clothing, Footw (Apparel)8.5%9.5%4.08%4.89%6.70%3.60%3.73%5.50%4.05%
04 Housing (in US/Japan only shelter)17.2%10.7%26.16%30.80%15.90%31.96%32.60%26.40%21.22%
Fuels & Util for housing (only US/Japan)5.10%5.13%7.04%
05 Household5.6%8.54%4.75%5.59%6.81%4.41%4.70%5.80%3.45%
06 Health9.6%3.83%14.63%4.03%4.20%6.63%6.23%3.60%4.28%
07 Transport10%16.06%10.83%13.19%15.60%17.30%17.69%12.80%14.21%
08 Communication(incl. in transport)2.88%2.94%3.10%3.20%3.31%3.14%3.60%(incl. in transport)
09 Recreation&cultural13.8%6.64%9.56%11.57%9.50%6.30%5.65%12.40%11.45%
10 Education(incl. in recreation/cultural)1.19%0.67%0.74%1.10%3.11%2.94%0.40%3.34%
11 Resto, Hotel (US: "food away home")11.95%8.84%4.40%9.20%5.93%6.17%5.80%(rest. 5.3% incl. in food)
12 Miscellaneous (US "personal care")8.45%5.46%7.44%8.50%2.59%2.55%5.80%5.59%
SourceChina StatisticsIstatSwiss StatisticsDestatisEurostatBLSBLSSweden StatisticsJapan Statistics

Chinese CPI basket before and after March 2011 adjustment

The real Chinese CPI basket effectively contains 31.8% for food, but the Swiss basket contains only about 11.0% in this category. Typically poorer countries have a basket with a higher weight for food and other consumption goods, but richer states give them a smaller weight.

Absolute measures for Purchasing Power Parity (PPP) have different major defects:

• They include both tradable and non-tradable goods. Non-tradable goods must be more expensive in richer countries. Therefore, the difference between poorer and richer countries is accentuated.
• They use a single product as comparison basis for all countries. A non-tradable good, especially locally produced food is not useful, given that quotas or taxes might exist.
• Or they use standardized consumption basket with the same weights per category applied to all countries, even if the consumption basket in a richer country is different.

### Relative purchasing power parity measures

Relative measures compare prices changes for different countries between today and a base year (for example last year).

According to WikiWealth the PPP is the same as the Inflation Rate Parity:

Inflation Rate Parity (relative purchase price parity): Inflation decreases the value of money over time; whereas, investors seek to increase the value of their money over time. The currencies of low relative inflation countries will increase in value as demand for their currency increases.

WikiWealth uses inflation rate parity to have another indication of currency value. It helps to show the loss of value to currencies with high inflation rates. If one country had a significantly higher inflation rate than the target country, money would flow from the high inflation rate country to the low inflation rate country. WikiWealth uses the global weighted average to calculate expect returns, because investors are likely to search for a wide sample of countries for investment returns. Since inflation rates change quickly, and sometimes in unexpected ways, WikiWealth makes an adjustment to the inflation rate. The adjustment changes inflation rates over a span of five years from the current inflation rate to the long-term inflation rate.

Countries with higher interest rates typically need them to control inflation, which destroys value and potential over time. The net potential of the inflation rate parity approach is much less, because low inflation (good for investors) usually matches countries with low interest rates (bad for investors).

According to Investopedia the PPP is:

An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power.

The relative version of PPP is calculated as:

Where:
“S” represents exchange rate of currency 1 to currency 2,
“P1” represents the cost of good “x” in currency 1 and
“P2” represents the cost of good “x” in currency 2

### The difference between PPP and Inflation Rate Parity

For us the relation between PPP and inflation rate parity is the following:

A country which is able to continuously provide a better price/quality relationship for their tradable goods than another country has a competitive advantage, it has a higher productivity. This competitive advantage is translated into a higher exchange rate that makes their products more expensive on the global market again (i.e. PPP via producer prices). The higher exchange rate leads to cheaper imported products and via cheaper imported prime materials to cheaper production (Partial Canceling Out of FX Effects).

Cheaper imports reduce inflation, especially in small open economies with a high import share. This directly leads to the Inflation Rate Parity.

Reasons for this competitive advantage can be found in cheaper tax levels, better infrastructure, more availability of (human) capital (see more in chapter 11) and lower debt and risk.

### Differences between PPP based on producer and consumer prices

The movement of PPPs with the time can be measured based on the producer price index abbreviated as PPP-PPI, or in consumer price indices abbreviated as PPP-CPI. Moreover one could use the GDP deflator or potentially an absolute measure like OECD index. Since the CPI or GDP deflator includes services (e.g. hair cutting), the best PPP measure for tradable goods is the one for PPP-PPI.

The formula shows that the “relative price” of currencies with low increases in production costs/prices (1+PPI term) must appreciate with the time:

The PPP for EURCHF provided by UBS is based on producer prices and stood in June 2012 around 1.32.

source UBS

Due to the higher European (producer price) inflation, the PPP fell by November to around 1.30. Still by June 2013 it is around 1.30. UBS’s PPP has 1990 as base year. It decreases each year in which Swiss PPI is lower than European PPI.

The one from HSBC-Trinkaus  is based on the producer price index (PPI). For them the AUD, NZD and NOK are strongly overvalued against the euro, but the franc is nearly at fair value. In September, both the dollar and the yen were fairly valued.

With the Chinese slowing, the reality has followed HSBC’s anticipation and AUD and NZD have depreciated until August 2013.

By December 2012, both dollar and yen moved into undervalued territory. Here the current fair values (“fairer Wert”):

HSBC PPP PPI Fair values as of December 2012 (source HSBC-Trinkaus)

The Bloomberg PPP is based on the producer price indices (PPI).

The USD/CHF Bloomberg PPP stood at 1.01, but the one for USD/EUR is at 0.87 (inverted notation). This implies a PPP for EUR/CHF of 1.16, meaning that the Swiss franc is undervalued against the euro.

The differences among the valuations by UBS, Bloomberg, HSBC and KOF arise from the choice of the base year and base FX rate from which the formula above is started.  In the Bloomberg evaluation the PPIs since the year 2000 are used. The base FX rate is the average exchange rate between 1982 and 2000, while the UBS evaluation seems to use the year 1990 as basis.

#### PPP based on Input Producer Prices vs. PPP based Output Producer Prices

The producer price index is typically based on output prices of local producers and on prices of exported goods. Statistics bureaus in certain countries like the UK are able to provide a differentiation between input and output price indices. The input PPI include costs of prime materials, capital and labor. UK data for September 2012 showed that the YoY input PPI fell by 1.2%, but the output PPI (for home sales) rose by 2.5%. The stronger sterling and cheaper energy prices helped the improve margins of British companies.

We think that a measure based on output producer prices or export prices would be the best for a comparison of tradable goods.

## Summary

The following graph from the Swiss KOF institute gives a comparison of the different PPP measures for the EUR/CHF rate on the base year 2000 (and previously DEM/CHF, which is actually quite misleading).

• Exchange rate (CHF/EUR), red
• Relative Producer Prices (PPP based on PPI, not distinguished between exports and local consumption), black
• Purchasing Power Parity (PPP according to OECD), blue
• Relative GDP deflator, orange
• Relative Consumer Prices (PPP based on CPI), dark green
• Relative unit labor costs (ULC of the OECD), brown

Different Measures PPP in Comparison KOF

The purchasing power parity gives an understandable explanation if a currency is over- or undervalued. Even if we decide to use the PPP based on producer prices, still a lot of interpretation remains, for example, which base year should be used. Several factors, especially credit cycles (see first chapter), but points like immigration (see chapter 15) may divert the nominal FX rate from the “fair value” indicated by the PPP.

## Literature:

Balassa, B. (1964), “The Purchasing Power Parity Doctrine: A Reappraisal”, Journal of Political Economy 72 (6): 584–596, doi:10.1086/258965.

Dornbusch, R. (1988), “Purchasing Power Parity”, The New Palgrave Dictionary of Economics (Reprint ed.), London: Palgrave Macmillan, ISBN 1-56159-197-1.

Samuelson, Paul A.. A. (1964), “Theoretical Notes on Trade Problems”, Review of Economics and Statistics 46 (2): 145–154, doi:10.2307/1928178.

Samuelson (1994). “Facets of Balassa-Samuelson Thirty Years Later,” Review of International Economics 2(3), pp. 201–26. Abstract defining the Penn effect

Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.
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