laugardagur, apríl 04, 2009

isk, usd, and ppp

There has been a lot of talk around Iceland on what would constitute a "fair" value for the króna on foreign exchange markets. Many here are convinced that the ISK, currently trading at around 120 to the dollar, is far too weak. They understandably yearn for the days of 60 ISK to the dollar (and the fully loaded Icelandair 757s back from the Mall of America that followed), and since last fall, elected officials from former Prime Minister Geir H. Haarde on to those in the current government, publicly support the idea that the ISK can "recover" its value soon. The editorial desk here at the IR remains skeptical.

The economic theory of purchasing-power parity (PPP) states that, in the much-maligned "long run", currencies should buy the same amount of goods and services in each country. The theory says that a dollar or a Euro or 100 ISK should buy the same amount of "stuff" whether those monies are spent in Reykjavík, Paris, or New York. There are of course some assumptions here: sales/VAT taxes and transport costs being the same everywhere are among them.

The most cited example of this absolute version of the theory of purchasing-power parity is The Economist's Big Mac index. The magazine periodically looks at the price of a Big Mac burger in all sorts of locations around the world and uses those prices to say whether the local currency is over- or undervalued against the dollar. So what does it say about Iceland? In the most recent version of that index that included the ISK, from July 2008, the ISK (then trading at 79) was a "whopping" 67% overvalued against the dollar. The "correct" price for the ISK was 131 to the dollar, at least according to the benchmark price of a Big Mac in one of Reykjavík's shady McDonalds stores. As it has many times since its inception, this Big Mac Index correctly predicted the future movement of a currency, in this case predicting the massive devaluation for the ISK that began within a month of the article's publication.

Another way to look at this idea of PPP is relative purchasing-power parity. This theory says that the movement of the exchange rate for a pair of currencies can be predicted by the inflation differential of those currencies over time. (So if Japan has zero inflation, and the U.S. 5% inflation over some period, the dollar should lose 5% of its value relative to the yen over that period.)

To look at relative PPP here, I ran the numbers for the ISK versus the dollar since the beginning of the decade, when there were around 72 ISK per dollar according to Landsbanki. I used the U.S. Consumer Price Index and the Icelandic Vísitala neysluverðs (the local CPI) to glean the inflation numbers. Since the beginning of 2000, the U.S. dollar has lost almost 26% of its value (meaning if a coffee cost a buck in 2000, today it would cost $1.26) and over the same period the poor, sad Icelandic króna has lost around 72% of its value (if a singed svið cost 100 króna in 2000... I'm sure you get the point). Running all of this through the relative PPP formula, the fair value of the ISK today, relative to what it was at the start of the decade, is 98 krónur to the dollar.

These two measures make admittedly pretty wide predictions for the fair value of the currency today, and the choice of the beginning of the decade for my analysis is somewhat arbitrary: if I had chosen a different starting point I could have come up with a very different number. But I think the take-home should be fairly clear: with a high-inflation currency such as our beloved króna, ever-increasing exchange rates relative to more stable currencies is the norm. And despite what the politicians (or your own desire for a golf trip to Scotland) might tell you, where the ISK is today might be just about right.

Sources: The Economist, Landsbanki Íslands, Hagstofa Íslands, U.S. Bureau of Labor Statistics


Anonymous Kristrún Tinna said...

I prefer to look at the real exchange rate, that is the relative purchasing-power parity. The real ISK exchange rate is currently 20% below its 20-years historical average (by looking at long-term average the starting point does not dominate the outcome). So based on that this average is still relevant (which is not necessarily the case), the long-run “equilibrium” should involve a stronger ISK. Other countries hit by a foreign exchange crisis have experienced very low real exchange rates for a number of years following the crisis. The half-life of decrease averages 2-5 years. Therefore it should be stressed that this is a long-term approach and I find it highly unlikely that the real exchange rate of the ISK will be back to average any time soon.

In the short-run, however, it is clear that the on-shore FX rate of the ISK is way stronger than it would be without the capital controls. The gap between on-shore and off-shore exchange rates has been widening: the EURISK is currently traded at 160 on-shore compared to over 250 off-shore rate.

These are my thougths, but like a true economist I have no universal conclusion.

Anonymous Nafnlaus said...

Nice try, Jared.
Your calculation is correct but the underlying assumptions, model, whatever you want to call it, are not.
The ISK value is the amount of ISK in circulation, or potential circulation, in relation to the value of assets that can be bought.
Here's some comments on the subject by some poster on the internet:
"The general exchange rate you see quoted in the press therefore reflects two things - the productive economic capacity of a country (which includes its capital assets) and the amount of the currency in circulation (with special regard to that circulating outside the country).

So let’s look at Iceland. Well as we’ve seen a good proportion of productive capacity of the country is already pledged to foreigners through the secured bonds. So we can’t use those to back up the general currency. What’s left? Not much, lets call it zero in fact. How much ISK is outside the country? Loads. Divide loads by zero and you get a very high number indeed!

160 ISK/euro - in your dreams.
260 ISK/euro - you will get this as an implied rate if you are an Icelander with something worth buying on the unofficial market (such as selling fish in Grimsby).
100000 ISK/euro - that’s probably nearer the correct value.

What does this mean? Well the analysis shows Iceland is bankrupt (the immediate claims against the country are beyond the value of all the future output of the country). Bankrupt means the currency is worthless. That means the exchange rate is almost infinite. Worthless means that real inflation is stratospheric"

Superman 007

Anonymous Nafnlaus said...

Jared. In case you're interested in the source post for that quote, it's over on IceNews:

From his other posts, the chap that posted it really does appear to be a "Nordic analyst". Not that that makes him right though :) .

On a related note, there's been a fair amount of talk about the recent Silfur Egils interviews with Hudson and Perkins (linked below). I've yet to see anything about the ramifications of kicking out the IMF, nationalising and/or defaulting. Do you have a take on it?


Anonymous Nafnlaus said...

Have to respond to the second Nafnlaus: the true productive capacity of Iceland lies in its people, their skills, training and their sheer drive to be assets. An infinite exchange rate is the most 'bogus' of economy anywhere can have a zero asset base. Economists run and hide when it comes to things they can't measure and they measure only what they can put into monetary form. When I worked in Africa, with a family "GDP" of $125/year, no account was made of the hand built mud huts with straw roofs or the value of a women walking two Kilometers to fetch water. Only the yams sold in the market. Let's get real.FB


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