Big Macs, Price Differentials, and Single Currency Areas

I fortuitously came across this while looking at something else:

What does the Big Mac say about Euro Area adjustment?

The Big Mac Index offers some quick insights into the state of currencies around the globe by comparing the price of Big Macs across countries. Of course, the Big Mac index was never intended as a precise gauge of currency misalignment, as the Economist has just reminded us in its latest update. According to them, it is just about making PPP and other difficult exchange rate concepts more digestible.

Well, in the euro area, we have the euro to be able to simply compare prices across the euro area. So how have Burger prices moved recently? Are prices in the euro area adjusting? Should we be pessimists or optimists on the adjustment challenge in the euro area? Since July 2011, the Economist has also been collecting the individual prices of Big Macs in major euro area countries...

Forex Fallacy

[This post is loooong. For those without patience, you can skip to the end without missing too much]

Tong Kooi Ong talks forex policy and promptly makes a meal of it:

How the middle class is subsidizing the Corporate Elites and why it has to stop

There is a feeling that Malaysia’s middle class are generally not a happy lot. Many moan about the rising cost of living, education and healthcare, their relatively low wages and rising debt as they borrow more to buy homes and cars…

…A major problem lies in the weak ringgit, which results in different purchasing power for the two “middle classes”…

Quis Custodiet Ipsos Custodes

I’ve always had mixed feelings about criticising news report and editorials. On the one hand, I realise that it could take away the focus of this blog from the purpose I intended for it, which is to cover developments in the Malaysian economy. I ‘m also fairly sure that such posts could make me come off as petty (I plead not guilty) or intellectually arrogant (maybe guilty as charged).

Against that, there’s the role of the press in reporting and commenting on national policies (which has an impact on political accountability), and its role as opinion leaders. If there are mistakes in this arena, whether by omission or commission, then there is some value in pointing those out even if I don’t have the reach that they have.

Of course, whether you consider a particular viewpoint a “mistake” really depends on one’s point of view and educational background.

I think I’ll continue to have ambivalent feelings about this issue, but will proceed nonetheless.

BTW, if it seems I pick on The Star too much, it’s because out of the major English dailies I find that, right or wrong, they actually do have something to say about the economy. The News Straits Times appears to be interested only in human interest stories and sports. Ok, that was exaggeration, but justified exaggeration IMHO.

To round up some the articles that caught my interest this weekend:

1. Managing Editor P Gunasegaram thinks marketing Bursa Malaysia is putting the cart before the horse, and we should put our economic house in order first. For once, I fully agree with him.
2. Raymond Roy Tiruchelvam asks to consider purchasing power parity when comparing incomes in other countries, if you’re considering immigrating. I only ask that you don’t try using it for comparing the level of exchange rates unless you want another scathing editorial on this blog! BTW, instead of using the Big Mac Index (what, again?), I would use the World Bank’s International Comparison Program, or the Penn World Tables. Either would give a better multi-product idea of the differences in the price levels.
3. Angie Ng talks about normalising the costs of borrowing and investing in property. But she makes the odd statement that, “Normalising the interest rates by allowing it to be decided by actual market forces of demand and supply is certainly more healthy.”  Sorry to break this to you Ms Ng, but whether BNM sets the OPR at 0% or 10%, interest rates are market determined. All the OPR does is set a 50bp band to the overnight rate, everything else is determined by the demand and supply of money. Of course with the OPR target, BNM has its hand on the scales so to speak in terms of the money supply, but demand is entirely free to vary. There’s also in the article the meme that low nominal rates disadvantage deposit savers, which is not necessarily true – it’s real rates that matter, and those generally rise during a downturn unless the central bank cuts the nominal rate. Had to point that out, sorry.
4. Jagdev Singh Sidhu rounds up opinions from various research houses on the strength of the economy given the great numbers we’ve seen the past couple of months. The consensus is that the recovery is credible, but we should see better evidence on its sustainability in the second half of the year. It was pointed out by a few analysts that exports and industrial production are off their peaks of 2008. Way to go guys! But if you consider 2008 as a bubble year (which I do), then the recovery is over – we’re now back to the growth phase, and growth sustainability is a much harder question to answer. Again everyone seems hooked on analysing growth statistics (even if they note the base effect), and most are not bothering about the actual levels. And no one noted that poor capital goods imports are a direct result of the excess capacity that already existed before the recession started. Don’t look for high capital goods imports this year, it just ain’t coming. Nor will the lack of it say anything at all about manufacturers’ plans, intentions or prospects.

Burgernomics: Where's The Beef?

I was going to give this article a pass, but I had a little epiphany over the weekend that makes it worthwhile commenting on - not so much the article itself, but rather the example Tan Sri Lin See Yan makes of The Economist's Big Mac Index (here and here for the latest readings).

The Big Mac Index was based on a simple idea: since the Big Mac is relatively homogeneous (same ingredients, and almost the same in terms of other inputs), differences in pricing across countries should illustrate differences in purchasing power, and thus gives a clue as to the relative strength or weakness of exchange rates.

For example, the average USD price of the Big Mac is $3.57 while the average EUR price is €3.31 as at July 13th, which gives an implied USDEUR exchange rate of USD1.08. Comparing this to the actual USDEUR exchange rate of USD1.39, according to this measure the EUR is 29% overvalued against the USD.

If we take Malaysia as an example instead, with a local price of RM6.77 we get an implied-PPP exchange rate of RM1.896 compared to the actual of RM3.60, giving an undervaluation of 47%. If you look at most East Asian countries, you'll find a greater or lesser degree of undervaluation.

This type of analysis has therefore tended to confirm the stylised notion that East Asian economies are currency manipulators, and have kept their currencies cheap in relation to the USD to boost their export-growth models. I won't delve into more formal proofs (and dis-proofs) of this notion, but rather go into the potential hazards of relying on the Big Mac index as a PPP measure.

The standard critique is that Big Macs incorporate local inputs, which are generally composed of non-tradables (land, labour, localised taxes etc). I'd also add the potential for price differentiation from local supplies of tradables, particularly the ingredients themselves - beef, bread, vegetables etc, although the sauce as I understand it is a McDonalds monopoly.

This could explain much of the gross difference between countries, if you've followed my arguments based on the tradables/non-tradables model of exchange rate determination. Also, The Economist themselves warn that the Index should only be relied upon when comparing economies with similar income levels, a finding that is also derived from the same model - high-income countries have higher price levels, and would therefore have stronger currencies in relation to lower-income economies. Looking at the index, we do indeed find developing economies in general having derived-PPP levels lower than that of advanced economies.

The epiphany I was talking about earlier focused on something quite different, which could also strengthen the argument against a Big Mac Index as a PPP measure. When I was a student in London in the late 1980s, I was struck by the fact that Coca-Cola and many other global food and beverage brands had very similar prices to Malaysia's (admission: I'm a Coke addict) - on the face of it, this would imply the intuition behind the Big Mac Index was correct.

But looking at McDonalds' menu prices a different story emerged: Big Macs were indeed more expensive in the UK (and not just in London). Here's the kicker. While Big Macs were more expensive, Filet o'Fish were actually cheaper in the UK than in KL, on par with the humble Hamburger.

What that suggests to me are a few additional economic explanations, over and above the conventional critique:

1. The difference in prices between low-income and high-income economies can also be attributed to differences in the ability to purchase higher-protein diets. As countries shift from low-income to high-income, the protein intake of the population increases raising demand (and prices) for beef.

2. Differences in prices can also be attributed to consumer preferences for different types of protein. Honestly, how often do you see Asians eating beef as compared to chicken, fish or pork?

3. As a corollary to the above, access to alternative supplies of protein (for instance, access to the seas) would also impact beef demand.

Just as important as these factors are that Big Macs are not tradable - there's no price arbitration across borders because Big Macs are a perishable good, unlike for instance a can of Coke. Also, McDonalds is a multi-national corporation with a globally-recognisable brand. To me that suggests that it also likely practices price differentiation across markets, which is a characteristic of monopolies.

So there are quite a few more factors involved than just the conventional economic explanations for differences in purchasing power based on the Big Mac Index, and hence implied-PPP evaluations of exchange rates. A Filet O'Fish Index for instance could paint a very different picture of PPP between East and West.

Proving all these formally might take some doing, but I think I'm going to make a stab at it. It'd make for a decent publishable paper.

Exchange Rates and Purchasing Power Parity: Why PPP Only (Sort Of) Works

I made a couple of assertions in my previous post that deserve some clarification.

First, I said taking some absolute level of the exchange rate as the equilibrium level, and thus making it the reference point at which you can judge whether a particular exchange rate is “weak” or “strong”, only works if you believe purchasing power parity (PPP) actually holds. Since PPP in its absolute form does not in fact empirically hold, this sort of analysis is inherently flawed. Second, I gave the opinion that since Malaysia appears to be shifting to a deliberate policy of promoting the services sector as the future engine of growth, the exchange rate must necessarily appreciate. These two statements are in fact intimately related, and actually come from the same analytical framework.

To begin, let’s examine the underlying principles of PPP. Take a world with two economic actors and two different currencies– a small open economy (A) and the Rest of the World (B). Only one good is produced and consumed (called W), and that good is globally traded with no friction (i.e. no transport costs, tariffs or taxes). The price of the good is then determined by global supply and demand, and applies to everyone equally (since A is small and thus a price-taker). There are only two factors of production, capital and labour, with constant returns to scale technology and where capital is freely mobile but labour is not. The exchange rate between currencies A and B will simply be the relative price of good W in A and B – in other words, the exchange rate equates the local price of W in both economy A and economy B. That in essence is what PPP says – prices of goods should be equal anywhere in the world after adjusting for the exchange rate. Extend that to the factors of production and in equilibrium, wages and interest rates should also be equal.

Adding complications to this model doesn’t change the underlying principle – trade friction and inflation only adjust the exchange rate required to equalize prices. You can even add stuff like foreign risk premiums or productivity differentials, but nothing fundamental will change – prices should still be equal after these additional costs are taken into account. You can see why PPP is both a powerful and seductive concept: it makes sense, and appeals to people’s sense of symmetry and fairness.

If structural and policy changes to economies happen simultaneously and symmetrically, then absolute PPP will hold – i.e. there is some level of the exchange rate than can be called the relative true value of each currency. If changes do not occur homogeneously, then weak-form or relative PPP will hold – i.e. changes in variables will cause relative changes to the exchange rate. For instance, higher inflation in A would require a weakening of the exchange rate relative to B, but the domestic prices would still equalize to their previous level.

Empirical testing for weak form PPP is thus fairly simple – all you have to do is prove that the real exchange rate (the nominal exchange rate adjusted for inflation) is stationary i.e. it reverts to its previous equilibrium level. Proof for strong form PPP is obtained if the equilibrium level is also equal to unity.*

*If anybody wants to find out how this is done, drop me a line in the comments.

Empirically however, proving PPP has been highly problematical – real exchange rates don’t revert; or if they do, the movement is so slow that it can’t be proven that PPP holds. In fact, most early alternative models of exchange rate determination found little evidence that any single factor actually determines exchange rate movements (e.g. interest rate parity and monetary models).

One possible explanation for the empirical failure of PPP to hold is what’s known as the Balassa-Sameulson hypothesis (henceforth BSH for short). To illustrate the concept, let’s extend our model by adding another good, X, which is produced in both A and B, but is not tradable. The domestic price of X will be determined by local supply and demand, and not at the global level. This implies that the price of X can only be equalized globally under very special circumstances. Why this matters is the impact on the returns to the factors of production – if the price of X is not equalized, then wages cannot also be equalized globally (under the assumption of capital mobility, real interest rates would).

If demand for good X is higher in economy B, then wages would be uniformly higher in economy B relative to A, which reduces the productivity of B in the tradable sector (the production of W) because production costs are now higher - B's supply curve for W shifts left, because of the competition for labour for production of X. Since the supply of W is now lower and wages are higher in economy B, B’s domestic price of W will rise. In response, since PPP still applies to good W, the exchange rate of currency B relative to A must necessarily rise to equate the domestic prices. A will ceterus paribus produce more of W which will be exported to B, producing a trade surplus and a relatively weaker currency for A.

The only point at which the exchange rate would be identical to our first PPP model is if the relative size of the non-tradable sector to the tradable sector in A and B are the same. If they are not, then the equilibrium exchange rate must necessarily be different from the PPP model, and PPP will not hold for all goods and wages.

Here are some of the main implications of BSH:

1. A country with the tradable sector growing faster than the non-tradable sector will have a depreciating real exchange rate, and vice versa;

2. A positive productivity shock in the tradable sector (thus lowering production costs and prices) will result in a weaker real exchange rate, and vice versa;

3. A positive productivity shock in the non-tradable sector will result in a stronger real exchange rate, and vice versa;

4. It is not possible for the absolute form of PPP to apply to all goods, which rules out some notional nominal value of the exchange rate as a permanent, time-invariant equilibrium exchange rate;

5. The equilibrium exchange rate is thus time-varying, depending on the relative strengths of the non-tradable sector in each economy and their growth paths. QED

Thus, when applied to Malaysia, saying for instance that RM2.70 to the USD is the true equilibrium rate for the MYR may have been true in the early 1990s, but is unlikely to be correct now – continuing trade liberalization (which reduces the external price of our tradables), a faster growing tradable sector, and the increasing service sector orientation of the US economy necessarily implies that the equilibrium exchange rate between the MYR and the USD has been falling. In reference to the MYR-USD peg from 1998-2005, BSH also suggests that far from having a “weak” currency policy, Malaysia’s USD exchange rate was actually closing on the equilibrium real rate despite being nominally fixed.

If we consider the multilateral rate (the real effective exchange rate), it’s thus not obvious whether Malaysia ever had a “weak” currency policy that lasted much longer than 1998-2001 – strength in the USD to that point also meant an appreciation of the MYR relative to other floating currencies, which effectively negated any price advantage in export markets and in fact put us at a disadvantage by 2002. To take another example of BSH in action, Singapore shifted to a more service-oriented economy in the wake of the 1997-98 crisis; it is thus no accident that in real terms SGD has appreciated against the MYR since then. BSH also explains why the Indian Rupee continues to have an elevated value, when other metrics suggest it ought to be considerably lower – a strong service orientation as well as relatively high tariff barriers support a more appreciated currency.

This neatly leads into the second assertion in my previous post that I wanted to discuss. The services sector is generally taken to be composed of non-tradables – it is usually difficult to trade services, particularly personal services (the example usually given in text books is that of barbers). Exceptions of course exist, like segments of the transportation sector (port services and airlines for example) or tourism, but generally speaking prices of services are determined mostly by local factors rather than global ones. Thus a future strategy that places the services sector as the engine for growth (as likely to be followed by Malaysia in the coming years), will ceterus paribus result in an appreciation of the true equilibrium exchange rate. Since BNM policy appears to be neutral relative to the level of the MYR (as opposed to its volatility) the nominal rate will also appreciate.

Therefore, a deliberate policy of strengthening the currency to raise domestic incomes is unnecessary – the currency will strengthen anyway with a more services-oriented economy, as local wages are bid up by labour demand from industries which do not suffer from international price arbitrage. Nor is targeting some mythical nominal value of the exchange rate (particularly against the USD) economically sensible or viable – the equilibrium exchange rate can and will vary, depending on the relative balance between the tradable and non-tradable sectors in Malaysia as well as in each of our trade partners.

Of course, evidence of BSH is as hard to find as that of PPP, hence the reason it remains labeled a hypothesis rather than a theory. The main hurdle is fairly simple to articulate but almost impossible to overcome – it is extremely hard to make a distinction between what constitutes a tradable good and a non-tradable good. Government consumption is typically used to proxy the effect of BSH in empirical models, but that is under the (sometimes dubious) assumption that most of government spending falls on non-tradables. Some services sectors are subject to international competition as mentioned before, while most tradable goods contain elements of non-tradable inputs.

Nevertheless, BSH does appear to explain much of why exchange rates tend to persistently resist reverting to PPP values, as well as why some currencies are “stronger” than others. And it also explains why I have no faith in PPP-based judgements of “weakness” or “strength” in any currency.

Exchange Rate Policy 3: Equilibrium exchange rates

How does one tell whether an exchange rate is over- or under-valued? Driver and Westway (2004)* lists 11 different methodologies on how to do this. If you recall from my first exchange rate policy post, structural models have the potential for making this determination. The insight into using these types of models is that exchange rates are affected by many factors, not just one or two, i.e. currencies should move in relation to the underlying fundamentals of an economy. If this sounds familiar, it’s because this is a common refrain of Tan Sri Zeti when talking about the level of the MYR. By implication, the fundamental equilibrium view rejects the concept of purchasing power parity or PPP, or alternatively that the PPP changes across time (depending on which model you use).

*Rebecca L Driver & Peter F Westaway, "Concepts of equilibrium exchange rates", Working Paper no. 248, Bank of England (2004). Link is here - warning! PDF link.

Which fundamentals are important to which currency can be radically different – a lot of the time spent in specifying these models is determining which variables actually matter. For instance, for countries like Malaysia with strong natural resources, commodity prices are an obvious starting point, although there are many more factors to take into account. A non-exhaustive list of fundamentals would include:

1. Government consumption, which is presumed to fall more on non-tradables. Higher government consumption in that case should in theory (through the Balassa-Samuelson Hypothesis) cause an appreciation of the exchange rate;

2. Relative real interest rates, where higher rates cause appreciation;

3. Openness to trade, where higher openness allows for greater tradable goods arbitration. This will equate to a depreciation of the exchange rate;

4. Net foreign assets, which measures capital stocks. A typical approach is to take changes in stocks as the variable i.e. a flow approach using changes to the current account, or the international investment position. The impact depends on the policy stance and structure of the economy – where economic growth is slower, a higher net foreign asset position implies greater income flows which result in an appreciation. However, empirical evidence suggests in high growth periods or for fast growing developing economies, capital inflows can appreciate the currency despite decreasing the net foreign asset position;

5. The terms of trade, which measures the price of exports in terms of imports. The result on the exchange rate here depends on the relative strength of income and substitution effects, although the empirical evidence suggests the former. This implies an appreciation of the exchange rate;

6. Relative productivity, both internal (between the non-tradable and tradable sectors) and external (in tradables). Higher international productivity in the tradable sector suggests a depreciation, while higher productivity in the tradable sector relative to the non-tradable sector implies an appreciation;

7. Demographic structure, such as the dependency ratio.

I have seen a lot of variations and proxy alternates in the variables used, some due to specific country effects and others due to data limitations. Some of the variables, such as trade openness, are subjective. Government consumption sometimes is not significant, but the government deficit might if borrowing is primarily external.

The different modeling approaches also yield different estimates of the equilibrium value of the exchange rate. There is in fact no single, correct way to go about this. The consensus is to always apply two or three different modeling approaches, which should give a good ballpark figure as to how far a currency is off its “true” equilibrium value. If on the other hand all the models are pointing in one direction, then that is something our fictional central banker has to take seriously. In terms of actual use, I would take the following three models as the most prevalent:

1. Macroeconomic Balance model (MBM) – measures the difference between projected medium term current account balance with an estimated equilibrium current account balance.

2. External sustainability model (ESM) – a variant of the MBM model, but measures the difference between actual current account balances with the balance that would stabilise the net foreign asset position at some benchmark.

3. The Reduced Form Structural Model – equates the medium term equilibrium exchange rate as a direct function of medium term fundamentals. The term "reduced form" indicates that variables that don't impact the exchange rate are dropped from the specification i.e. these aren't "full" structural economic models.

These are the models in general use by the IMF* in assessing currency misalignments, and where possible all three are calculated to get a balanced view of a currency’s equilibrium position. I’m not about to lay out in any length of how the models are calculated – even within the broad categories above, you can use different statistical approaches in the estimation, and results may vary according to the sample period chosen as well as the presence of any structural breaks.

* Press statement here, PDF document here

Neither is data gathering a trivial exercise. If you take the 15 currencies I’m using in my short term broad MYR index, that means you have to have the required data for all the variables for all the currencies involved, and in the correct frequencies for the full sample period selected. Secondly, some of the theoretical concepts don’t translate well to real world data – such as for example trade openness – which requires using some form of proxy. Third, some data is just not collected, or available for limited periods or not accurately measurable, such as net foreign assets. There’s thus a lot of room for specification error and measurement error.

Even with those caveats, there’s still no alternative to making the attempt at measuring currency misalignments. Any currency that is not following a full free float with open capital account regime can get into serious misalignment problems, with potentially expensive adjustments required to regain equilibrium either through currency adjustments, real economy adjustments or both. The worse case of course, is when these adjustments are imposed by the market, as we saw in 1997-98.

This naturally takes us to the choice of exchange rate regime, which will be covered by the next post.

Exchange Rate Policy 1: Concepts

If it seems I’ve taken a break from blogging, it’s because I’ve been hard at work reconstructing my MYR exchange rate indexes. Since I’m still in the midst of refining them, this post should serve as a holdover until that’s done.

Nothing in economics is quite so confusing as exchange rates. The problem is that exchange rates are in essence relative prices, not absolute prices, and because in a world of multiple exchange rate regimes, making sense of exchange rate movements can be complicated. For instance the chart below shows the cumulative movements of the Ringgit against the G3 currencies since 2000 (2000=100):



Relative to the start date, Ringgit (MYR) is 6.9% stronger against Dollar (USD), 9.5% weaker against Yen (JPY), and 26.9% weaker against the Euro (EUR). Can we therefore say that the Ringgit is generally weaker or stronger? More to the point, what are the implications for policy and trade? At what stage should authorities decide that a currency is overvalued or undervalued enough to merit intervention? These and other questions will be the topic of this series of posts I’m embarking on.

The most intuitive and attractive concept of exchange rates is the theory of purchasing power parity, or PPP. In its strong form, PPP states that the same good should have the same price everywhere (aka The Law of One Price). Therefore the exchange rate of any two currencies should equate this price in local currency terms. For example if a Big Mac is RM8 in Malaysia, and US$2 in the USA, then the PPP exchange rate should be US$0.25 if we use MYR as the base and RM4.00 if we use USD as the base. If PPP is true, and the actual exchange rate is RM3.80, then we could consider the MYR as being 5% overvalued against the USD.

Unfortunately, empirical evidence for strong form PPP is patchy even over periods of hundreds of years. There is better evidence for weak-form PPP, where prices differ but the difference is constant. Even here, the proof is not absolute as exchange rates appear to deviate from the PPP predicted value for extended periods. The last 60 years has seen a lot of effort to decipher how this can be, given the importance of the exchange rate to international trade and the balance of payments.

One notion, called the Balassa-Samuelson effect, suggests that only tradable goods face price arbitrage in international markets and PPP should hold for these goods, but not for non-tradable goods and non-tradable components such as tax structures, property rentals, and so on. This effect should be particularly strong in services, which by definition are difficult to trade (imagine the relative value of the haircut for instance). The general effect of a strong non-tradable sector is an appreciation of the exchange rate.

Another school of thought focused purely on monetary effects and the impact of real interest rate differentials, called the concept of uncovered interest parity. The idea is that capital flows to where the real yield is highest, which in turn moves the exchange rate to equate the relative differences. Since investors view countries as having different risk profiles, a risk premium can also affect the exchange rate, which is the concept of covered interest rate parity. Inflation should also have an impact, as it is a measure of the relative supply of each currency – the higher the relative inflation rate, the more a currency is expected to depreciate.

The problem with these and other theories is that, taken in isolation, none do a good job of explaining exchange rate movements in the floating rate period (1972 onwards). The best statistical model of short term exchange rate movements is and remains the random walk, which in statistical notation is:

X(t) = X(t-1) + ε

Notice that this differs substantially from a simple regression model in that there is no intercept and no slope to the equation. What the random walk model states is that the best predictor of tomorrow’s market price is today’s price!

So what is a poor central banker to do? What finally made sense, at least in identifying medium to long term movements of the exchange rates, were structural models which put a lot of these concepts together. In real life therefore, it’s a combination of factors that influence the exchange rate, not one or two. But before models like these can be used, we have to figure out how to actually arrive at a single view of a currency rather than the multiplicity of rates that any currency is subject to, which will be the subject of the next post.