Economists take the PPP out of price comparison

PUBLISHED : Thursday, 04 February, 1999, 12:00am
UPDATED : Thursday, 04 February, 1999, 12:00am

Don't pay much attention to purchasing power parities (PPP), say most economists. They're too weak an influence on exchange rates.

It's tempting to do so, nonetheless.

The idea is straightforward enough. If your country's exchange rate 10 years ago was 100 to the US dollar and your country's inflation index has risen by 50 per cent more than US inflation over that period, then theoretically your US dollar exchange rate now should be 150 to keep your prices in line with US dollar prices.

Economists are wary of the idea for two reasons. The first is that balance-of-payments pressures have a much greater impact on exchange rates and they don't always go the same way.

The second is that too many things get in the way of simple cross-currency price comparisons, for instance taxes, transport costs, shop rents and mad forex traders who risk millions because they feel lucky.

It is tempting, however, and particularly in Asia right now, so let's do the exercise.

The top line on the first chart is what you get if you take the US dollar exchange rates of all the currencies of the region excluding the yen, restate them as indices where January 1989 equals 100 and then aggregate them by size of gross domestic product. From 100 in January 1989, you go to 199.5 in December last year.

Now do the same for regional inflation indices. Set them to a new index base of January, 1989 equals 100, total them up by size of GDP, take the relative movement of the resulting figure against the US inflation and you go from a starting value of 100 to only 143.1 in December.

What this says is that on a simple PPP basis, Asian currencies have fallen far too much against the dollar.

Those jagged breaks on the currency line pre-1997 are attributable to devaluations in the mainland, without which you would have a line that remained virtually flat until mid-1997. This says that, yes indeed, most Asian countries rigged their currencies until that time.

Even then, those currencies crashed far more than their simple PPP measures against the US dollar would have led them to do.

The table shows how great the scale of those differences has been in some cases. Indonesia may have deserved what it got, but the rupiah is almost 70 per cent cheaper than it would have been on inflation differences with the US over the last 10 years.

And as for devaluation talk in the mainland, you won't easily hear the proponents of it arguing their case on a PPP basis with a currency 60 per cent cheaper than its theoretical PPP level.

There is one currency that stands out on this exercise as significantly overvalued - our Hong Kong dollar is 34.8 per cent stronger than these figures say it should be.

Don't expect a Hong Kong booster to let it go unremarked. There is not enough space left in this column today, but tomorrow, unless other events intervene, you'll get the argument as to why you have to look at Hong Kong differently.