Australia | Sep 07 2010
By Greg Peel
If anyone ever wondered whether economists might have too much time on their hands…
Economics 101 suggests all free-floating currencies must tend towards a value based upon something called “covered interest arbitrage”. To explain what this means I'll relate a story regarding an English friend of mine resident in Australia. Let's call him PB (I'll leave you to interpret the acronym).
PB wanted to obtain a mortgage in 2008 when the RBA cash rate was at 7.25% and mortgage rates were heading toward 10%. But a phone call with his sister back home revealed that mortgage rates there were closer to 4%. Given PB still had an English bank account, he asked me why he shouldn't use that to acquire a mortgage at a much cheaper rate in England than he would have to pay in Australia even though he wanted to buy an Australian house.
Because whatever you save on the cheaper rate, said I, you'll lose on the exchange rate when your English bank lend you pounds and you have to pay for your house in Aussie dollars. It will end up at about the same result. Otherwise, everyone would be doing it.
In other words, exchange rates must adjust to differences in interest rates or there is an “arbitrage” opportunity to borrow in one currency and invest in another for a guaranteed profit.
However, while CIA, as it's known, makes perfect sense, it still doesn't actually work perfectly in practice. If it did there never would have been more than a brief opportunity to apply a “yen carry trade” which allows, among other things, Japanese investors to borrow in yen, buy Aussie bonds, and pocket a profit despite having to repatriate back to yen again. There are other forces at work.
To that end, another popular exchange rate comparison measure is that of “purchasing power parity”. The PPP measure dictates that a ubiquitous, generic, every day item should cost the same everywhere across the globe once adjusted for the local currency. A litre of milk has always been the popular item of choice.
So if an American could buy a litre of milk at home for US$2 say before flying to Zimbabwe, even if a litre of milk cost Z$2,000,000,000 in Zimbabwe by the time he exchanged his US dollars for Zim dollars he'd find he'd only be spending US$2 again. If he only had to pay an equivalent US$1 then the Zim dollar is clearly undervalued to the reserve currency. If he had to pay an equivalent US$3 it is overvalued.
In recent times, nevertheless, The Economist magazine has updated the PPP measure by publishing the Big Mac index, given the global ubiquity of Scottish restaurants. The Big Mac is arguably a better product by which to assess floating currency values against the value of the reserve currency given the price of a litre of milk is determined locally, but the price of a Big Mac is controlled from the US.
But CommSec argues that even Big Macs don't offer a true parity measure given they don't trade across borders. They are “manufactured” locally even though the profits ultimately end up back in Oak Brook, Illinois. To achieve a true parity measure, one must compare the price of a product that is manufactured in one place and exported across the globe. That product must still be relatively ubiquitous, so CommSec has, since 2007, chosen the Apple iPod. Apple has just released a new iPod Nano, so CommSec has just had a chance to update its “iPod Index”.
This iPod costs US$149 in the US before local charges and taxes. If the Aussie dollar is “correctly” valued, then an American should be able to fly over here, change his greenbacks for Aussie, and buy an iPod for the equivalent of US$149 before local charges and taxes. But right now, he would actually have to fork out US$165.80.
This is determined by the current exchange rate of US$0.9160. For our American to buy an iPod in Australia for the equivalent of US$149, the exchange rate would have to be closer to US$0.83. Therefore, CommSec suggests, the Aussie dollar is about 10% “overvalued”.
Or maybe the US dollar is 10% “undervalued”. Indeed, in an index consisting of 33 countries and currencies, the iPod is cheapest in the US itself. It is most expensive in Brazil.
CommSec's index does not adjust for freight costs. But then Apple manufactures its iPods in China, so even Americans pay freight. But indeed, CommSec provides plenty of reasons why iPod prices might be different across the globe, such as Apple wishing to sell cheaply into the larger consumer base in the US.
Indeed, CommSec notes that the price of an iPod in Australia hasn't moved for two years, despite the Aussie rising from US66c to over US91c in that time.
Which begs the question: Who is wrong here? The Aussie dollar or Apple's price-setting team. Another question might also be asked of CommSec: Who on earth cares?
Well CommSec argues that an overvalued Aussie will ultimately impact upon Australian consumer spending.
Some of you may remember back in the days when currencies didn't float so freely that half of Australia used to fly to Hong Kong to buy a “cheap” stereo. I certainly remember that whenever I went to New York in the eighties I would load up on “cheap” Brooks Bros business shirts. CommSec argues that if an iPod is cheaper in Australia than in the States, Australian consumers will go to the States to buy one.
Or more realistically, if goods are cheaper offshore, they can be purchased cheaper in Australia on-line (freight costs assumed) at the expense of local retailers. So retailers beware – the Aussie is overvalued.
At least if you look at iPods. My Brookes Bros shirts were cheap by comparison because we didn't have free trade agreement with the Yanks back in the eighties and the duty was about 100%. But by the same token, I could buy Brookes Bros shirts off the rack at Barney's in my size because Brookes offered various different combinations of waist, neck and sleeve length. Australian shirt retailers offered no such range, given there weren't enough slim 6'4” buyers to justify the inventory. I could go to a tailor, but that cost not just the arm but the leg as well.
My point is that trying to come up with a ubiquitous product is fraught, given so many other factors are at work. Freight is one obviously, but so is population, culture (What would a Hindu pay for a Big mac? Nothing, they're vegetarians), and simple demand. That the iPod has not changed price in Australia for two years tells me more about the demand for iPods in Australia than it does about the global demand for Aussie dollars.
