# Undervalued Currencies, Part I

Editor’s Note: Today’s post is from Dick Locke, Sourcing Innovation’s resident expert on International Sourcing and Procurement. (His previous guest posts are still archived.)

The value of the Chinese currency, the renminbi is getting a lot of attention. The renminbi is commonly called the yuan, and I’ll use that term here. Economists, lobbyists, legislators and others are all saying the yuan is undervalued. I agree with them.

But undervalued compared to what? Often the answer is “compared to what it should be”. That’s really vague and circular. There is one common point of comparison, though. That’s the “Purchasing Power Parity” (PPP) exchange rate. It’s not perfect reference point though. In this two-part post I’ll be covering:

• Background of the PPP rate
• How to determine the PPP rate for different countries
• How to calculate over- and under- valuation
• Countries with big differences between the PPP rate and the actual rate

Background PPP rates

The concept of the PPP rate came largely from the World Bank. They were trying to give a realistic picture of the relative standard of living between different countries by looking at per capita Gross Domestic Product (GDP). Each country measures GDP in its own currency, and that figure has to be converted to a common currency to compare countries. The common currency the World Bank uses is the U.S. dollar. They found that converting GDPs at the real exchange rate gave an unrealistically low view of the standard of living in developing and poor countries. For example, in 2009 the annual per capita GDP in China using real exchange rates was only about \$3,300 per person. But a person can live much better in China on that level of income than they would in the U.S., so the World Bank developed a PPP exchange rate that shows the per capita income to be \$6,600, using a PPP rate to convert from yuan to dollars.

So how is a PPP rate determined? It’s based on a market basket of consumer-oriented goods and services. It’s the exchange rate at which that basket would cost the same in both countries. What exactly is in that market basket? I haven’t been able to find that information. I do know that it’s heavy on food, clothing, housing and education costs. It may not have much relevance to industrial purchasers.

Here are two quick examples of one-item market baskets. I live in Mexico most of the time. I can see a first-run movie in a modern theater that’s equivalent to the best in the U.S. for 45 pesos. In the U.S., it would cost \$10. The PPP rate for movies in Mexico is therefore 4.5 pesos per dollar (45/10). That’s the exchange rate at which costs would be identical. However, if I were to buy a laptop computer in Mexico, an \$800 laptop in the U.S. would probably cost 13,000 pesos. That implies a PPP rate for computers of 16.25. (The real exchange rate is about 12.5 pesos per dollar)

More well-known, the Economist magazine periodically publishes a one-item “Big Mac” Index of PPPs by comparing the prices of Big Macs around the world. You can see some recent results by following the link.

In the next post, we’ll cover the determination of PPP rates, the calculations necessary to determine value against the US dollar, and list some countries with large differences between the PPP rate and the actual rate.

Thanks, Dick!