PPP analysis with FX exchange rates
Last time, we gave an easy example of PPP – a simple model of exchange rate determination that defines relation between the exchange rates and the prices of goods in different countries – the Big Mac Index.
A more sophisticated one was developed by the Eurostat and OECD and its computation is described in their manual called Eurostat-OECD Methodologies Manual on Purchasing Power Parities. It gives a better approximation of the PPP, which is difficult to measure as countries can have different baskets of goods or different weights in their price level measures. We are not going to go further in the three-stage calculation of the PPPs, all we need to know here is that it gives a more accurate value of the PPP than the Big Mac Index, and therefore is used by many academics and practitioners.
Below, we are going to provide three different analyses of FX spot rates (GBP, JPY and CAD) against the PPP values since the collapse of the Bretton Woods system in 1971.
GBPUSD: In the early 1970s, Cable was way undervalued compare to its PPP value, which converged slowly to the FX spot rate around 2.10 in 1979. Then, for the next three and half decades, we can say that the Exchange Rate has oscillated around its fundamental PPP value (Chart 1). The only big divergence we saw was in the 1980s as a consequence of the Federal Reserve increasing its interest rate up to 18% to fight inflation coming from the second oil shock (Shah Revolution in Iran). This sudden tightening cycle gave birth to the Dollar Reagan Rally between 1980 and 1985, which could explain the reason why Cable diverged sharply from its fundamental value. This rally was halted after the Plaza Agreements in September 1985 (in which the major central banks pledged to work towards a weaker US Dollar and a reduction of US Current Account Deficit) and the FX spot rate converged back toward its PPP level. Since 1990, the spot rate has more or less traded around its fundamental value.
The recent drop that pushed Cable below its fair value are the consequences of Brexit (more details here) as the pound was clearly hurt from investments outflows (i.e. property funds) and new easing measures announced by the Bank of England (25bps rate cut in addition to 60bn GBP QE expansion within the next 18 months). We could see more divergence [from the fundamental value] as the UK is clearly on its way to reach a ZIRP policy in the near future, which would add pressure to the British pound.
Chart 1. GBPUSD spot rate (red line) versus PPP (black line)
USDJPY: In 1970, the fundamental value (PPP, black line) was estimated at around 225 while the FX spot rate was fixed at 360 JPY per USD. The Japanese currency was fairly undervalued (against the USD) for a long time according to economists, which could explain the large current account surpluses mainly driven by exports due to a cheap currency (click here for more details about The History of the Japanese Yen). After Bretton Woods ended, the Yen experienced two decades of appreciation against the greenback and constantly traded below its fundamental value between 1985 and 2013.
Then, the new measures launch by the trio Abe/Kuroda/Aso in 2012-2013 led to a massive Yen weakening period and the exchange rate eventually crossed over its fair value [according to Eurostat-OECD PPP] in 2014. The results of Abenomics levitated USDJPY from the mid-70s level in Q3 2012 to a high of 125 in June 2015, while the PPP index remained quite steady at around 105.
However, the weak global macro environment (lower global growth, Brexit and the European Banks, Fed delaying its tightening cycle…) in addition to no further BoJ stimulus (more details here) has played in favor of the Yen over the past year; USDJPY declined sharply below its fundamental value and is currently flirting with the psychological 100 support. The real now question now is how far will the Japanese Government [and the BoJ] let the currency pair diverge from its fundamental value on the downside before intervening in the market?
Chart 2. USDJPY spot rate (red line) versus PPP (black line)
USDCAD: For our last PPP analysis, I chose a commodity currency: the Canadian Dollar also called the Loonie (Chart 3). It is pretty clear that all of the three charts show us that over a long period of time, the FX spot rate tend to mean-revert towards its fundamental value if it diverges too far away from it. I think that it is interesting to look at how commodity currency exchange rates (i.e. the Loonie) react vis-à-vis their fair PPP value. As opposed to the British pound (Chart 1), we can see that USDCAD FX spot rate is much more volatile [relative to its PPP value], and therefore USDCAD tends to divergence much more from its fundamental value and for a longer period of time. For instance, we first had an important divergence during the Reagan Rally where USDCAD rose from 1.15 to 1.40 (which means strong Canadian Dollar depreciation against the USD), but more importantly during the 1990s Clinton Rally when the Fed started a tightening cycle. The divergence is also explained by the sharp decline of the Canadian Dollar in the 1990s. The 90-91 recession that followed a significant interest rate increase, fiscal and political uncertainty during the mid-1990s in addition to the Quebec referendum of 1995 led to a progressive weakening of the Loonie (M. Devereux, 2008). On the top of that, the Asian financial crisis in 1997 led to a fall in commodity prices, which obviously accelerated the Canadian Dollar meltdown. USDCAD reached an annual average high of 1.5700 in 2002 [according to OECD data] and the market was speculating on a Fall of the Loonie.
The situation reversed then and between 2002 and 2011, we saw a dramatic appreciation of the Loonie. It looks to me that the more a currency diverges from its fundamental value, the sharper the reversal is. This long period of Loonie strength could be summarize by the Super-Commodity cycle led by the elevated growth coming from Emerging Markets (the famous BRICs).
We can observe another important reversal in 2012, which has mainly been explained by the end of the super-cycle. Since 2012, commodity currencies (i.e. AUD, NZD, CAD or ZAR) suffered dramatic losses due to a decreasing global demand (slowing growth coming from China, the fall of Russia then Brazil, Fragile Fives…) which impacted the commodity market. The Loonie is once again undervalued according to the PPP Fair Value and the situation is not going to get better anytime soon I believe. Therefore, we could see further divergence from the fair value in the medium term (12-18 months) and LT mean reversal shorts should wait for the exchange rate [USDCAD] to reach higher levels.
Chart 3. USDCAD spot rate (red line) versus PPP (black line)
- Real Exchange Rates
The real exchange rate (RER) seeks to measure the value of a country’s goods relative to those of another country at the prevailing nominal exchange rate. It is defined by the following formula:
Qt = St * P’t / Pt
Where P’t represents the price of foreign goods,Pt represents the price of domestic goods and St the nominal exchange rate.
If [absolute] PPP holds, therefore the real exchange rate Qt =1 as the price of goods would cost the same in the domestic country (i.e. United States) as in the foreign country (Great Britain) when the price is expressed in a common currency. However, we saw in our three cases that PPP doesn’t hold as FX spot rates tend to be usually overvalued or undervalued compare to their fundamental value.
From the formula above, we know that the competitiveness of the foreign country improves when Qt < 1as the foreign currency is undervalued according to the PPP model that we used. On the contrary, if Qt > 1 , the foreign currency is overvalued and the competitiveness of the foreign country deteriorates.
In our examples, we have the following results:
GBPUSD: Qt = 1.325 / 1.40 = 0.9464 < 1, which means that British Pound is undervalued vis-à-vis the US Dollar.
USDJPY: Qt = (1/100) / (1/104) = 104/100= 1.04 > 1, the Japanese Yen is currently overvalued against the US Dollar according to PPP.
USDCAD: Qt = (1/1.2850) / (1/1.2150) = 1.2150/11.2850= 0.9420 < 1, i.e. the Canadian Dollar is undervalued against the greenback.
Even though the RER indexes between two countries, a more interesting measure would be the Real Effective Exchange Rate (REER) which gives a bilateral RERs average between the domestic country and each of its trading partners, weighted by the trade shares of each business partner. Therefore, our next lecture will be on how to calculate a REER series for a specific country and see if that country has an undervalued or overvalued exchange rate respective to its trading partners.
Devereux, Michael (2008), The Rise of the Canadian Dollar, 2002 2008
OECD (2012), Eurostat|OECD Methodological Manual on Purchasing Power Parities
Catao, Luis (2007), Why Real Exchange Rates?