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.)
In our last post we discussed the undervaluation of the yuan, introduced the Purchasing Power Parity (PPP) rate as a measure of the relative valuation of a currency, and reviewed the background behind the PPP rate. In this 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.
The Determination of PPP rates
You can look them up in a very wordy and meandering World Bank publication. However, the World Bank does not update values very frequently. The most recent data is from 2005. The CIA in the United States publishes an annual World Factbook. It has data that enables an easy calculation of current PPP rates.
The Factbook shows GDP at both PPP and “official” exchange rates. In the case of China in 2009, GDP at PPP rates was 8.789 trillion U.S. dollars. (Note to non-U.S. readers: A trillion in the U.S. is 1,000,000,000,000.) GDP at official rates was 4.814 trillion dollars. Because both GDPs are conversions of the same amount of yuan, if you know the official rate simple algebra will give you the PPP rate.
How can you find the “official” rate? In most cases, it’s the actual rate. If you use the “Historical Exchange Rates” facility at oanda.com, it will give you an average exchange rate over a period of time. The average rate in 2009 was 6.841 yuan per dollar.
That means the PPP rate was 3.74 yuan per dollar. (I left the algebra to you.)
Calculation of Over- and Under- Valuation
There’s a big difference between 6.84 and 3.74. How big? First you need to re-express exchange rates into dollars per yuan. That means simply inverting each value, or dividing it into 1. If there are 6.84 yuan per dollar, each yuan is worth 14.62 U.S. cents. At 3.74 yuan per dollar, each yuan is worth 26.69 cents. The difference between the two values is 11.93 cents. Take that difference (11.93) and divide it by the PPP value and you get .452, or 45.2 percent of the PPP value. That means the yuan is undervalued against its PPP value by 45.2%.
Other Countries
If you do similar calculations on other countries, you get results that will dispel any notion that floating currencies settle near the PPP rate. You will also see that China isn’t different than many of its competitors.
With this method, some countries’ currencies are undervalued against the U.S. dollar. In turn, the U.S. dollar is undervalued against some countries’ currencies
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Summary
- PPP rates are calculated based on consumer purchases, not industrial products.
- China is one of several countries that have both currency controls and an exchange rate that is significantly different than the PPP rate. However, removing controls and floating a currency does not guarantee it will reach PPP rates.
- Individual buyers (and sourcerers) should not concern themselves with official PPP rates because these consumer-oriented rates may be very different than the rates for the particular product a buyer is handling.
Thanks, Dick!