Actual Exchange Rates in the Developing World and Purchasing Power Parity

While purchasing power parity (PPP) is not a major factor in determining a country's actual exchange rate, it can be used as a rough guide in deciding whether a particular currency is under or over valued.   Most developing countries with growing current account balances, have preferred to pile up foreign exchange reserves rather than let their currencies appreciate.  Meanwhile, the purchasing power parity of their currencies has generally increased slowly and steadily as their economies have prospered. As a result their currencies have continued to be undervalued.

Data on the purchasing power parity of currencies can be derived from data in the Haver data base, The World Development Indicators.  The data are annual so the latest data point is 2008.  PPP conversion factors for the world countries are included in the section "Exchange Rates and Prices".  We  chose four countries as examples: China, Korea, Singapore and Brazil and the PPP Conversion Factor (GDP) to market exchange rate ratio.

The conversion factor is the ratio of PPP exchange rate to the actual exchange rate. One minus the conversion factor, therefore is the percentage of under or over valuation of the particular exchange rate relative to the dollar.  Thus for Korea,  the conversion factor of .684 in 2008 means that the Korea's actual exchange rate was 31.6% undervalued relative to the dollar.  Since the actual exchange rate is 1102.09 Won/$, a conversion factor of .684 means that the PPP exchange rate is 753.98 Won/$ (.684 * 1102.09).  The actual exchange rates, the PPP exchange rates and the percent of undervaluation of the currencies of the four countries are shown in the table below.· Brazil has allowed its currency to appreciate considerably.  From an undervaluation of 61.9 in 2002, the Rial was only 18.4% undervalued in 2008, as shown in the first chart.  By contrast, China has permitted only moderate appreciation of the yuan as shown in the same chart. The Singapore dollar has steadily reduced its undervaluation as can be seen in the second chart.  Korea, on the other hand experienced a sharp increase in its undervaluation in 2008, also shown in the second chart.

The third chart brings up to date the actual exchange rates of the four countries.  They have, to varying degrees, appreciated in 2009.  Again, the Chinese Yuan has appreciated the least and the Brazilian Real, the most.