Economic analysis

There is no such thing as a ’fair value’ for the loonie

The dollar is worth what someone is willing to pay for it

In a recent blog post, Unifor economist Jim Stanford argues that the loonie was overdue for a fall since it was above its fair value:

At or near par with the U.S. greenback, the loonie was substantially overvalued by any fundamental measure. The most common way to estimate the “fair value” of a currency is according to relative price levels in different countries (what economists call “purchasing power parity”). On this basis, the Organization for Economic Cooperation and Development pegs the loonie’s benchmark at 81 cents (U.S.). [You can see the whole set of OECD PPP estimates here.]

Temporary factors (like investor expectations, big financial flows, or unusual success in export markets) can push the exchange rate away from its fair value – for a while.

But even waterfowl can’t stay aloft forever, and it’s been clear for years that eventually the loonie must come back to earth.

The idea that currencies quickly converge to their purchasing power parity (PPP) values is one of the most persistent myths in economic discourse. The data shows otherwise; deviations from purchasing power parity can and do persist for several decades. The World Bank has a publicly available data set, for the period 1980-2012, called PPP conversion factor (GDP) to market exchange rate ratio that compares the value of a country’s currency (in U.S. dollars) to the value the currency “should be” based on PPP. A value greater than 1 indicates that the currency is overvalued by PPP theory, a value less than 1 indicates the currency is undervalued. Five countries provide a terrific example of the type of persistence that is possible:

PPP Conversion ratio for Denmark, Norway, Korea, South Africa and Singapore

As you can see from the chart, Norway’s currency has been overvalued by PPP for 33 consecutive years from 1980-2012—often significantly so. Denmark shows a similar pattern, except for a dip below parity between 1982–1985. Korea, South Africa and Singapore have been “undervalued” by PPP each of the last 33 years. I restricted my analysis to relatively wealthy countries, as developing countries tend to have significantly undervalued currencies.

The Canadian data also shows that PPP deviations often persist for significant periods of time:

PPP Conversion Ratio for Canada

The Canadian dollar was significantly undervalued by PPP for the 12 year period from 1993-2004. The loonie has been overvalued since 2006, but an eight year deviation from PPP is not particularly unusual.  A 20% over-valuation (a ratio of 1.2) is also not unusual; Norway has had a ratio above that level in 27 of the last 33 years, with the ratio peaking at 1.63 in 1980 (and 1.62 in 2011).

The truth of the matter is that there is no fair value for a currency. A currency—like any other good or service in our economy—is worth whatever someone is willing to pay for it. Purchasing power parity is one force that influences currency movements, but it is only one force of many. PPP plays a stronger role in currency movements in theory than it does in practice, a phenomenon that has puzzled economists for decades. In some instances, the half-life of PPP deviations (the length of time it takes for an exchange rate to move halfway to their PPP value) has been estimated at ten or more years, though other studieshave disputed these findings.

Large and persistent deviations from PPP are the norm, not the exception. We should not be surprised when they happen.