Purchasing Power Parity and the Big Mac

According to the Purchasing Power Parity (PPP) Theory of exchange rates, currencies should adjust so that the prices of a similar basket of goods costs the same in different countries and is used to examine whether a currency is currently over or under-valued. If the current exchange rate between sterling and the US dollar is £1 = $1.50, we would expect that if a  basket of goods  cost £100 in the UK  it should cost $150 in the USA .  However, if the basket only cost $100, travellers from the UK to the USA would find that their pounds, when converted into dollars, were buying more in New York than they could purchase in London and sterling was overvalued.

The PPP exchange rate is also used when comparing living standards in different countries. GDP per capita is the most common method but there is a problem with the exchange rate. The UK GDP is measured in sterling while the US uses dollars. If the exchange were stable AND reflected the prices of goods in the two countries, there would not be a problem. However this is not the case. As an illustration, consider that the £:$ exchange rate has fluctuated between £1 = $1.49 in 2016 and £1 = $1.25 in 2019. Depending on when one made the comparison, it might look as if the UK standard of living had fallen significantly over the three-year period. Therefore, using a PPP exchange rate, which uses the cost of similar baskets of goods, avoids the problem of a fluctuating exchange rate.

The use of PPP exchange rates can have a significant impact when looking at a country’s income. In India, the predicted GDP per head for 2020 rose from $2,500 per person to $8,900 when a PPP measure was used, indicating that goods and services there were cheap and the Indian rupee was significantly more valuable than indicated by the exchange rate  while in Norway predicted GDP per head fell from $79,000 to $69,000, showing that goods are services in Norway were relatively expensive.

However  PPP’s use brings different problems. Calculating the cost of a comparable basket of goods is a complex process  – think what you might have for breakfast at home compared to what you would eat in France. Since 1986 The Economist has published its own, non-scientific, PPP measure based on the price of a Big Mac in different countries. (An alternative to the Big Mac particularly in countries where the eating of beef is not common is the Starbucks Grande Latte Index). The Big Mac Index is useful as a quick guide to whether or not a currency is over or under-valued. Last year a Big Mac cost $5.58 in the USA but SFr6.50 or $6.62 indicating that the Swiss franc was overvalued by almost 20%. However if you wanted to fill up on Big Macs, the best place would have been Russia where it cost 110 roubles or $1.65, showing that the rouble was significantly under-valued.

The PPP is not an accurate predictor of short-term changes in exchange rates since speculation and interest rate changes can move currencies quickly. However, over a long period, the concept is valid. According to The Economist, currencies which, according to the Big Mac Index, were undervalued, appreciated over a 10 year period and vice versa.

UK exports,  the falling value of sterling and global supply chains

Since the referendum in 2016, sterling has fallen from £1 = 1.27 euros to 1.18 euros today and from $1.45 to $1.31.

Traditional economic theory predicts that a fall in sterling will lead to an increase in the quantity of exports and, as long as the percentage increase in quantity exceeds the drop in the value of sterling, then the value of exports will increase. This will not be immediate because demand for exports is inelastic in the short term, as it takes time for UK exporters to pass on the fall in price and for foreign buyers to appreciate it. Even if UK firms do not cut prices in overseas markets, the higher profits they are now receiving from exports should encourage them to devote more resources to their export markets.

Therefore, since sterling has fallen by 12% since 2015, we should, by now, be experiencing a significant improvement in our export sales. However they have not generally responded as hoped. A key reason for this has been the development of highly integrated supply chains.

If one thinks about the processes involved in manufacture, the first stage might be  design, then raw materials will need to extracted and refined, then components  need to be manufactured, the whole product assembled, then packaged, marketed and, at each stage, transported along the supply chain. In today’s economy, the number of firms solely responsible for the manufacture of their goods is tiny and, for products with thousands of components, the process will be extremely complex, involving goods crossing borders many times.

After a fall in the value of sterling, the price of all imported raw materials and components will increase, as will the cost of fuel needed to transport components and the finished product. Therefore, exporters will find that, rather than being able to cut their prices by the full extent of the drop in the value of the currency, they will have to take account of the higher costs of their imported components and raw materials, thus reducing the beneficial impact of devaluation.

A second factor in recent years has been an increase in the importance of non-price factors, such as marketing, reliability, the ease of obtaining spare parts and delivery dates. Therefore price elasticity of demand has become less important.

Ironically, the UK companies gaining the most from the fall in sterling have been those with significant earnings overseas since these, when converted into sterling, are now worth more.

The impact of a fall in sterling.

Since the referendum in 2016, sterling has fallen from £1 = 1.27 euros to 1.16 euros today and from $1.45 to $1.32, having dropped to 1.1 euros and $1.25 earlier in the month, and there is talk about further falls depending on whether we do or do not reach an agreement with the EU. For those looking for a longer perspective, £1 was worth $4 after the Second World War, dropped to $2.8 when sterling was devalued in 1949, then $2.4 when it was devalued again in 1967 and it fell once flexible exchange rates were introduced during the 1970s.

Economic theory predicts that the fall in sterling would lead to an improvement on the current account of our balance of payments as exports of goods and services increased because of their fall in price while imports, now more expensive, dropped as UK consumers and businesses sought cheaper alternatives. The size of the changes in imports and exports are determined by the price elasticity of demand, summed up by the Marshall Lerner condition which states that a devaluation or depreciation of the exchange rate will improve a country’s balance of payments if the sum of the price elasticities of demand for imports and exports are greater than one. The improvement is not immediate because demand for imports and exports is inelastic in the short term, giving rise to the J Curve effect where, following devaluation, a country’s balance of payments first deteriorates and then improves. Even if UK firms do not cut prices in overseas markets, the higher profits they are now receiving from exports should encourage them to devote more resources to their export markets.

Therefore, we should, by now, be experiencing a significant improvement in the balance of payments but this has not happened. In the time following the fall in sterling, the quarterly deficit in goods increased from £31.2bn (March – May 2016) to £34.7 (September – November 2018).  So why has the balance of payments not improved? Firstly, there is recent evidence that some companies are stockpiling imports (both components and finished products) in case of a disorderly Brexit. Another current issue has been the relatively slow GDP growth in UK export markets which has reduced the demand for our products.

There are two more significant reasons for the failure of our trade balance to improve and these cast doubt on the validity of using devaluation to improve one’s balance of payments. Firstly, because of globalisation, supply chains are highly integrated, with UK firms needing to import far more components to manufacture products than twenty years ago. Therefore, exporters will find that, rather than being able to cut their prices by the full extent of the drop in the value of the currency, they will have to take account of the higher costs of their imported components and raw materials, thus reducing the beneficial impact of devaluation. Secondly, the validity of devaluation depends on the price elasticity of demand and, increasingly, non-price factors, such as marketing and reliability, are becoming more important. Unfortunately, as Brexit nears, short-term doubts over its impact on such things as delivery dates and the ease of obtaining spare parts, will not help boost our exports, irrespective of the exchange rate.

So how is the economy doing?

This week has seen the publication of considerable economic data and much of it is contradictory, making it hard to tell exactly how well the UK economy is (or is not) doing.

In the year to March 2017, household spending in real terms returned to levels not seen since before the financial crisis, reaching £554 per week. The UK budget deficit has fallen and was £2.6bn in December, compared with £5.1bn in December 2016, and almost half economists’ expectations. This was partly due to higher than expected tax revenues from income tax receipts because of higher employment, higher VAT receipts and a refund on contributions to the EU. The positive news on the budget deficit means that government borrowing is likely to be at its lowest level since the financial crisis. Before celebrating too much, be aware, firstly, that the higher VAT receipts were due to higher inflation as well as to the growth in consumption and, secondly,  the refund from the EU was because the UK share of the EU budget has been revised downwards as a result of slower growth in the UK than the rest of the EU.

Another boost for the UK economy  was news that the employment rate had risen to a record high of 75.3% or 32.2 million, confounding forecasters who had predicted that the employment boom was over, based on the fall in October 2017 which is now being treated as a temporary fluctuation. At the same time as the employment level rose, the unemployment rate remained at 4.3% or 1.4 million, a 42-year record low. Equally encouraging was the shift from part-time work to full-time work which occurred over the period.

Further positive news  was that the economy grew at 0.5% in the last three months of 2017, faster than expected, largely because of the resilient service sector which makes up about 80% of the economy. As a result, growth last year was 1.8%, significantly higher than the 0.5% prediction by some disappointed economists following the Brexit vote. However, it is worth noting that the UK has dropped from being a growth leader to a laggard among the G7 countries, its growth rate is now at its lowest rate for the last five years and, given more rapidly rising incomes among our main trading partners, a slowdown in UK growth is disappointing.

On the downside, wage growth continues to be slow, meaning that real incomes are falling, the number of people starting apprenticeships fell by a quarter in the three months between August and October compared to last year, and sterling rose to its highest level since the Brexit vote. While this is good for importing businesses and holiday makers, it is less good news for exporters who have enjoyed the benefits of a low pound. It has also hit the share prices of companies with significant dollar earnings which are now worth less when converted into sterling.

Finally a word of caution; some of the figures, such as consumption spending, relate to the previous financial year while others, such as the growth in GDP, are subject to significant revision over time. Most recently, the figures for UK productivity have been questioned because the ONS might have significantly over-estimated inflation in the telecommunications industry and therefore underestimated the increases in its output. As a former Governor of the Bank of England pointed out, “trying to control the economy is like steering a car by looking in the rear view mirror”.

The exchange rate and the economy.

The traditional view of a fall in the value of a developed country’s currency was that it would lead to an increase in the value of their exports and a fall in the value of their imports, hence improving the balance of payments and, via the resultant increase in aggregate demand, cause an increase in employment and growth.

However the above analysis needs considerable qualification. Although a fall in the value of a currency will almost always increase the VOLUME of exports and reduce the VOLUME of imports, whether the values change in the same way will depend on the elasticities of demand for exports and imports. For a developing country whose exports are commodities with an inelastic demand, a fall in the value of the currency might worsen its balance of payments. Over time the UK’s exports have moved up-market and therefore it can be argued that they have become less price sensitive since factors such as design and quality become more important.

Secondly, the analysis assumes that firms can increase their production of exports to meet higher demand and this will depend on the state of the domestic economy, the availability of labour, raw materials and components. This is unlikely to be easy in the short term and economists talk of the “J Curve effect” whereby a devaluation initially leads to a worsening balance of payments as quantities of exports and imports do not change much, possibly because of long-term contracts or the difficulties in increasing output of export and import-substitutes and, only over time, will the balance of payments improve. While this might not apply to tourism, where people can switch their holiday destinations relatively quickly, high tech exports and imports of manufactured exports will be much slower to adjust. Firms need to take a view as to the permanence of any change in the exchange rate. In my last post, I wrote that the £:$ exchange rate fluctuated from $1.71 in July 2014, $1.32 after the Brexit vote, then to $1.21 in January, 2017, and was at $1.38 (20th January 2018) but at the time of writing (27th January 2018) it had risen to $1.42. Firms planning long-term contracts will need to take a view as to the likely long-term exchange rate and largely ignore short-term fluctuations.

We should also not forget the downside of a devaluation which is that imports become more expensive and therefore living standards fall. Not only does one’s foreign holiday cost more, but imported finished products and anything using imported components or raw materials becomes more expensive, with the increase in price depending upon how easily the supplier can pass on the increased cost to the buyer. As products become more complex and firms take advantage of globalisation, the supply chain becomes longer and there is a greater likelihood of imports being involved in some in the final product. Thus an increase in UK exports of goods is very likely to require an increase in imports needed to make our exports and some of the increased competitiveness will be lost by the higher cost of imported components and raw materials.

Recent examination of the exchange rate and UK trade in goods might suggest that the exchange rate  has a significant impact. In the last year the volume of UK goods exported rose almost 9% which would imply that the fall in sterling post Brexit has had a positive impact until one reflects that UK imports have increased by 7% during the same period, despite their increase in price. What this shows is that the exchange rate is simply one of many factors affecting the demand for imports and exports and we cannot ignore factors such as quality, income, interest rates or anything else which changes the desire to consume goods and services.

Nigeria’s dollar crunch adds to fuel crisis — FT.com


Refinery woes, currency controls and militant attacks combine to prolong acute shortage

Source: Nigeria’s dollar crunch adds to fuel crisis — FT.com

Inadequate infrastructure means that, despite being Africa’s top oil exporter, Nigeria has to import fuel putting downward pressure on the value of it’s currency, the Naira (see Chart 2 below). Value-added increases when oil is refined to become something more useful, in this case fuel, so the $’s received for each barrel of oil Nigeria exports is worth less than the $’s Nigeria has to pay for the same volume of refined oil, leading to a reduction in foreign exchange reserves (see Chart 1 below).

It is difficult to see how this cycle will end. If the value of the Naira continues to fall, the price of refined oil in Naira terms will continue to rise, further depleting foreign exchange reserves and accelerating the Naira’s depreciation.

There are several solutions, central bank intervention to revalue the Naira, but they need, already dwindling, foreign exchange reserves in order to manipulate the market price for the Naira. Investment in infrastructure, a fiscal supply-side policy, to reduce the reliance on refined oil imports is an alternative, but oil accounts for 90% of Nigeria’s export revenue and, subsequently, a significant proportion of government revenue. The price of oil has collapsed and with it government revenue, a classic example of the dangers of over-reliance on a primary commodity, prone to price volatility. The fall in foreign exchange reserves, the value of the Naira and an increasing budget deficit will make lenders nervous and will lead to an increase in the yield on government borrowing, put simply, the interest rate on government bonds will have to rise to offset the greater risk, increasing government expenditure on debt repayments.

Clearly, these options are not presently viable, but the second should have been enacted when the oil price was high and export earnings plentiful, however, corruption, some $16bn in government oil receipts is unaccounted for in the last year alone, has meant that infrastructure remains undeveloped.

A further consequence of the falling value of the Naira is that despite global oil prices falling, Nigerians have to pay more for petrol at the pump. To combat rising petrol prices the Nigerian government have imposed price controls, however, this has resulted in several-hour long queues and a rise in hidden market activity. Subsequently, Nigerians either face having to pay extortionate prices or waste valuable time queueing. Ultimately, output is lost and Nigeria’s economy suffers.

Nigeria’s relatively new president has a tough task on his hands.

Chart 1

Chart 2