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Foreign Exchange Rate Theory: The Purchasing Power Parity
After the strong revaluation of the Swiss franc in recent years, some economists, like the ones at the Swiss National Bank (SNB), claim that the franc is overvalued. Many use misleading Purchasing Power Parity (PPP) measures like the Big Mac index, the OECD index or the PPP based on consumer prices for computing fair values.
We explain why the PPP based on producer price indices (PPP-PPI) or export prices are the most relevant ones. It is shown that the commodity currencies, AUD, NZD and NOK, are overvalued but the Swiss franc is not. The Bloomberg PPP-PPI indicates that the franc is undervalued against the euro, while the PPP-PPI from the Swiss KOF institute indicates that it is slightly overvalued.
This suggests that the so-called “minimum exchange rate” of the EUR/CHF is actually a fair value and not a minimum.
We want to examine in this research if the Swiss franc is really overvalued. We recapitulate a big part of the foreign exchange theory concerning purchasing power parities.
The basis: 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.
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
Country Starbucks tall latte index McDonald's Big Mac Index
Australia -4 -17
United Kingdom +17 +23
Canada -16 -16
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 +6 0
Switzerland +62 +82
Taiwan -5 -21
Thailand -31 -46
Turkey +6 +5
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.
Country Price level (USA = 100) Country Price level (USA = 100)
Australia 157 Korea 80
Austria 111 Luxembourg 124
Belgium 117 Mexico 64
Canada 127 Netherlands 111
Chile 73 New Zealand 126
Czech Republic 80 Norway 160
Denmark 149 Poland 59
Estonia 84 Portugal 99
Finland 127 Slovak Republic 76
France 115 Slovenia 90
Germany 107 Spain 103
Greece 100 Sweden 128
Hungary 70 Switzerland 174
Iceland 118 Turkey 56
Ireland 125 United Kingdom 132
Israel 117 United States 100
Italy 99 Japan 149
Differences in CPI baskets
China . Italy . Switzerland . Germany . EU . US since 2008 US before 2008 Sweden . 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, tobacco 3.5% 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 Household 5.6% 8.54% 4.75% 5.59% 6.81% 4.41% 4.70% 5.80% 3.45%
06 Health 9.6% 3.83% 14.63% 4.03% 4.20% 6.63% 6.23% 3.60% 4.28%
07 Transport 10% 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&cultural 13.8% 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%
Source China Statistics Istat Swiss Statistics Destatis Eurostat BLS BLS Sweden Statistics Japan Statistics
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:
“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. 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.
Differences between PPP based on producer and consumer prices
PPP can be measured based on the producer price index abbreviated as PPP-PPI, or in consumer price indices abbreviated as PPP-CPI. Commonly producer price indices base on prices of the output of local producers and on prices of exported goods. Since the CPI includes services (like haircutting), the better PPP measure for tradable goods is the one for PPP-PPI.
The formula shows that currencies with low increases in production costs/prices (1+PPI term) must appreciate with the time:
The differences among the following valuations by UBS, Bloomberg, HSBC and KOF arise from the choice of the base year – the year 0. Bloomberg uses as base an average of the FX rate of several years.
PPP measured in consumer prices and the PPP in terms of producer prices, differ sometimes in Switzerland. These two measures differed quite strongly, not least because Swiss consumers are not very price-sensitive and Swiss importers had managed to collect high margins until September 2011 with the consequence that a special price control agency was created.
The PPP above provided by UBS is based on producer prices and stood in June around 1.32.
Due to the higher European inflation, the PPP fell by November to around 1.30. UBS’s PPP has 1990 as base year. It decreases each year in which Swiss PPI is lower than European PPI.
According to UBS’s PPP-PPI the US dollar is currently valued around parity against the franc.
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.
By December, both dollar and yen moved into undervalued territory. Here the current fair values:
The Bloomberg PPP is based on the producer price indices (PPI).
The USD/CHF Bloomberg PPP stands currently 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 Bloomberg evaluation has been based on producer price inflation since the year 2000. The base is the average exchange rate between 1982 and 2000. Since the dollar was relatively strong between 1982 and 2000, the correct USD/EUR PPP might be a bit lower.
For the EUR/CHF pair things are different, it mostly followed the trend line of the trade-weighted currency rate. Therefore it is difficult to doubt the accurateness of the Bloomberg fair value of 1.16 for the EUR/CHF.
This implies that Swiss producers have been and are competitive enough, not least thanks to a low tax level, cheap import prices and a continuing immigration of qualified labor. The strong current account is only one symptom of this competitiveness.
PPP based on Input Producer Prices vs. PPP based Output Producer Prices
Statistics bureaus in certain countries like the UK are able to provide a differentiation between input and output price indices (PPI). The input PPI include costs of prime materials, capital and labor. The most recent UK data 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.
Unfortunately, the Swiss Statistics Bureau does not provide producer price indices based on input prices. It is clear that during the strong revaluation of the franc, the Swiss producers took profit of smaller production costs. Still the bureau distinguishes between production prices for home sales and export prices. The latest data show that Swiss exporters do not have an issue to obtaining their desired prices. Thanks to the stronger dollar, export prices have even increased since September.
After the strong revaluation of the Swiss franc in recent years, some economists like the ones of the Swiss National Bank claim that the CHF is overvalued. Additionally these economists use misleading PPP measures like the Big Mac indices, the OECD indices or the PPP based on consumer prices. PPP based on producer price indices show that the commodity currencies AUD, NZD and NOK are overvalued but the Swiss franc is not.
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
It shows that the PPP-PPI calculated by the KOF is only slightly higher than the current EUR/CHF exchange rate.
Improvements of the KOF analysis
The KOF should have provided instead of the relative producer prices also the relative export prices. This would have given even more hints if the franc is overvalued or not. The second shortcoming is that they compare the period before 2000 with the German mark, but not with a composite of the euro countries PPIs.
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.