How do we know if a certain currency is under- or overvalued in comparison with another? A popular measure is purchasing power parity. This concept examines prices for similar goods in different countries, and then calculates the exchange rate needed to equate these prices if they were expressed in a common currency. This hypothetical exchange rate is finally compared with the actual one. By this measure the Swiss franc is expensive against most currencies. Will it automatically move toward parity? The plain answer is no, but as usual with economic concepts there is more than meets the eye.
On a transatlantic flight returning after Easter from Philadelphia to Zurich, a stewardess informed me that one euro equals two Swiss francs. “Alcoholic beverages like beer or wine will cost you 5 euros, 7 US dollars or 10 Swiss francs,” she said. This implied a EUR/CHF exchange rate of 2, a USD/CHF rate of 1.43 and a EUR/USD exchange rate of 1.40. The actual exchange rates at that time were respectively 1.2850 for EUR/CHF, 0.8750 for USD/CHF and 1.4680 for EUR/USD. So by the measure of beer sales in that aircraft in comparison with the exchange rate on the ground, the franc was 56% overvalued against the euro and 63% overvalued against the dollar. I point out, though, that the airborne EUR/USD rate was almost in equilibrium with the earthbound one.
As an economist, a savvy arbitrage opportunity sprang to mind: buy all the beers on the plane in US dollars, and then sell them to the other passengers for 9, 8 or even 7 Swiss francs, which would generate hefty profits. However, since I am not licensed to sell alcohol on a plane, I instead bought one beer for personal consumption and soberly reflected on purchasing power parity.
Obviously the beer measure is too narrow for sedate discourse of over- or undervaluation of a currency. The same critique can be made of the Economist’s Big Mac index, which in July 2010 showed the franc overvalued by 64% against the euro and 100% against the dollar. Looking at a broader index of prices such as producer price indices, which encompass internationally traded goods and should hence be able to equalize globally in the long run only helps somewhat. By this measure and using UBS Wealth Management Research estimates, the franc is currently overvalued by 26% against the dollar and by 10% against euro, and euro is overvalued by roughly 17% against dollar.
So Swiss exporters, who complain and suffer from the presently strong franc, actually do have a gripe. Even though the first quarter Swiss trade balance showed a surplus of 5.6 billion francs (4.1% of Swiss GDP).
I must remark, though, that taking purchasing power as an equilibrium value toward which the exchange rate will perforce move is a very static concept. In fact the purchasing power value is a moving target, the future value of which will depend on the difference in inflation rates between two countries.
Saying that the Swiss franc is 26% overvalued against the US dollar can mean that it will have to depreciate by 26% in coming years to arrive again at the equilibrium exchange rate. But the same effect of equilibrium exchange rate achievement could also come about via a significantly higher inflation rate in the US than in Switzerland, for example 5% higher over the next four years.
Therefore an overvalued currency also ultimately exhibits the confidence market participants have in monetary authorities to address inflation risks. Here they definitively have more confidence in the Swiss National Bank than in the Federal Reserve or in the European Central Bank.
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