Should 1 DM (deutschmark) be equal to 40 Macedonian denars?

By: Sam Vaknin, Ph.D.

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We are used to reading financial statements denominated in US dollars or to pay our rent in Deutsche marks. Economic indicators are normally converted to a common currency to allow for international comparisons. The exchange rates used are the official exchange rates (where foreign exchange persist) or market exchange rates (where the markets freely determine the exchange rates between the local currency and foreign currencies). The theory says that exchange rates are adjust through the mechanism of the market so that the prices in local currency of a group of identical goods and services represent equivalent value in other currencies. Put differently: 31 Denars should buy the same quantities of identical goods and services in Macedonia as 1 DM buys in Germany. Otherwise, one of the currencies is overvalued, the other one is undervalued and the exchange rate is "wrong" (sometimes, kept artificially wrong by the governments involved). This is the Law of One Price.

In reality, such adjustments do not reflect timely or accurately changing economic circumstances. The involvement of the state, for example, by imposing currency controls and by intervening in the markets (through the Central Bank and using its reserves), determining interest rates, slapping import tariffs, and introducing export subsidies distort the veracity of market- based exchange rates.

As long as goods are traded across borders, the possibility of arbitrage exists: the same goods can be bought cheaply in one place (call it territory A) - and sold for a profit in another (call it territory B), until the price equalizes. Prices tend to equalize, because there will always be someone who is willing to make less profit. He will sell (in B) at a reduced price which will be closer to the cheaper price that he paid in A. This way, the price mechanism will equate the purchasing power of the currencies of A and B: the same money will be needed to buy the same goods in A and B. Fiscal policy is considered to be of little consequence regarding exchange rates. The costs of transportation are ignored. In short, this ideal picture is very misleading. The reason is that many goods and services cannot be traded at all (non-tradables). Real estate, for instance. The relative value of such goods in A and B has nothing to do with the exchange rates. These goods are not part of the flows of currencies which determine exchange rates. They are bought and sold only in local currency. Their relative value is independent of the exchange rate mechanism and cannot be determined by studying it. To summarize: international comparisons based on market exchange rates usually greatly over- or understate the value of a nation's economic activity.

The Purchasing Power Parity (PPP) theories are the rivals of the Exchange Rate ones. The comparison is based on an evaluations of the purchasing powers of currencies - rather than on their exchange rates.

The procedure is fairly straight forward (and a little more convincing): the prices several hundred goods and services are regularly monitored (for instance, by the International Comparison Project (ICP) which operates in a large number of participating countries). The exchange rates are adjusted to reflect differences in purchasing power and thus to create purchasing power parity (PPP). PPP currency values are the number of units of a local currency required to buy the same quantity of comparable goods and services in the local market as one U.S. dollar would buy in an "average country" (in an average of all the countries). Sometimes, PPP comparisons are made against some base country. Could 55 Denars buy what 1 dollar buys in the USA? If so, the exchange rate is "right" because both currencies have the same purchasing power.

No article about PPP can ignore the "Economist Big Mac Index of Purchasing Power". The idea is ingenious: the Big Mac, the staple of the McDonald's restaurants, is almost completely identical the world over. In Beijing, Paris, Skopje and Tel-Aviv the same raw materials are put together in the same quantities to produce the same Big Mac. So, the Big Mac is really a "basket" of goods and services (the sales, cleaning, maintenance, accounting and so on) which is universal. In other words, it is a global index. By comparing the prices of Big Macs in various countries we can get a rough estimate whether the exchange rates properly reflect the relative purchasing power of the currencies involved. "The Economist" has been publishing the Index for a few years now and the results are amazing:

Exchange rates deviate wildly from real purchasing power. The Big Mac costs in the USA 2.58 USD (= 140 Denars). In Venezuela and Israel it costs 30% more. In Japan it costs 12% less, in Greece 20% less, in Russia 25% less, in Czech Republic 35% less, in Poland and Hungary almost 50% less. Translated to foreign exchange terms, the currencies of Hungary and Poland are 50% undervalued and the Israeli Shekel is 30% overvalued and should be devalued by the same amount.

In Macedonia a Big Mac costs 95 Denars - 40% less than in the USA! In other words: 95 Denars are the equivalent of 2.58 USD and the exchange rate should have been 37 Denars to the USD - and not 55.

This is a light hearted way of measuring PPP but all the international financial institutions agree today that the exchange rates used in their reports should be at least compared (if not actually adjusted) to reflect the purchasing power. The World Bank now uses both modes of presentation to present estimates of GDP. The IMF uses country weights based on PPP-based GDP for calculating growth rates and other economic indicators.

This has enormous implications. If this is true, the developing world's share of the economic activity in the world is larger than that adduced from the exchange rates. Granted, exchange rates provide us with a fair estimate of trade potential - but, after all, trade is only a part (and not the biggest) of the world economy.

As the new decade entered, the United Nations devised an index of Purchase Power Parity comparing the spending prowess of most of its members. The index included a basket of such items as average incomes, taxes, interest rates, insurance, utilities, gasoline, milk, newspapers and other typical expenses. As usual, the USA constituted the benchmark at 100. The first published index showed Greece at 35 (=three Greeks equal the purchasing power of one American consumer). A few more numbers:


So, what should be the exchange rate of the Denar? Skopsko and everything is possible: 37 Denars to the USD in McDonald's. Reality, however, is more grim. The (formal) average salary in Macedonia is 170 USD per month. Taking into consideration a 50% black economy factor, the real monthly wage is closer to 350 USD. This is still 10% of the average salary in the USA. The PPP theories ignore this important consideration. How strong (or weak) the currency is - is one important consideration but to say that it incorporates all the available information would be to miss the point. I am sure that the prices that McDonald's can and does charge in Skopje were influenced by the very simple fact that people have 90% less money here than in St. Louis.

Judging by the money supply, the availability of money through earnings, the wealth accumulation (savings rate and interest payable on M1 type instruments) - Macedonia is both inordinately illiquid and insanely expensive. To rent an apartment here costs 50-100 DM per square meter which is 60% of the rent in the most luxurious neighbourhoods in Tel-Aviv. Israel's GDP, however is 35 times that of Macedonia and the minimum legal wage is 900 DM. To my mind, there is little question that the purchasing power of the Macedonians is miserable. The combination of law wages and expensive prices sustained by a small rich elite is a clear sign of erosion of the power to spend of the great majority.

Other measures of currency parity are also unfavourable to the Denar. An important measure is the Covered (and Uncovered) Interest Parity (C/UIP). Roughly, it says that the differences in interest rates should be equal but opposite in sign to the (forward) exchange rate premium or discount between currencies.

Consider an American investor. Investment in either America or in Macedonia should yield the same return if the exchange rate risk is to be removed. If this were not the case, currency arbitrageurs would have moved in and made a profit. If the interest rate paid on the MKD is 10% and to borrow in American USD costs 6% - if the exchange rate remains stable, the investor will borrow USD, invest in MKD and earn 4% just by converting one currency to another (assuming free convertibility).

The fact that this is not happening in Macedonia proves that people still believe that the Denar is overvalued and should be heavily devalued. In other words: they think that the exchange rate risks are higher than the potential arbitrage profit. In a country far more dangerous than Macedonia (Israel) the foreign exchange reserves shot up by 130% (to 19.3 billion USD) precisely because of this: speculators converted dollars to Shekels to earn the high real interest that it offers in terms of dollars.

But, ultimately, exchange rates are determined by the supply and demand for the local currency relative to foreign currencies. This is a fundamental issue. In a country with a big trade or payments deficit, the demand for foreign exchange will exert pressure on the exchange rate of the local currency. In Thailand, Indonesia, Malaysia, Mexico - the trade deficit was less than 10% of GDP. Still, their currencies collapsed and were devalued by tens of percents, many times violently and in the space of a few horrible days. Macedonia's trade deficit stands at 16% (double that of Thailand's and Mexico prior to the demolition of their currencies).In a country with a big trade deficit, the fact that a currency is stable for a long time only means that it will collapse more spectacularly. It is like a pressure cooker: the more the lid is on, the higher the pressure and the resulting vapour. The trade deficit is covered by unilateral transfers from international financial institutions and donors. This is not a way to build a healthy currency (or economy, for that matter). Moreover, the bleeding of foreign exchange goes towards an increase in consumption. Investments of foreign exchange in capital assets (example: machinery and plant) generates enough foreign exchange in exports to recoup the outflow. Foreign exchange spent on cars and on caviar is foreign exchange lost.

The high interest rates in Macedonia and the infusions of capital from abroad keep the currency overvalued. Its appreciation is the result of conjectures not of fundamentals.

The writing is on the wall: a country which is running a large trade or current account deficit must balance its balance of payments with capital inflows (capital account surplus). If investors lose confidence in the country, capital inflows will cease (maybe reverse direction) leading to a depreciation (e.g., Mexico in 1994). For "investors" read in the last sentence "the international financial community". The important monthly "Euromoney" downgraded the credit rating of Macedonia (to the 151st place!!!) largely on these grounds. Current account + Capital account = change in gov't reserves. Today's reserves are sufficient to cover 2-3 months of imports. This is ample - but this is also temporary. The danger is imminent and the results could be catastrophic.

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