Is the won expensive? - The Korea Times

By Tim Condon

The question posed in our title is motivated by the results of a recent exercise in calculating Purchasing Power Parity (PPP) exchange rates. PPP exchange rates compare the prices of the same basket of goods in two countries. Several times a year, ING’s global team of economists goes shopping for a basket of goods and services.

The shopping basket includes 25 products and services. Within food, we price beverages, proteins, fresh fruit and vegetables and staples like sugar and spaghetti. The likes of shampoo, washing powder and magazines feature in the non-consumables category. Ninety-five octane gasoline or its closest variant is used for energy prices, and movie and subway tickets are the services prices in our basket.

We obtain a measure of a currency’s relative value ― whether it’s cheap or expensive ― by comparing it with the market exchange rate. We say the currency is under-valued or over-valued if the PPP exchange rate is stronger or weaker than the market exchange rate. We call the ratio of the PPP exchange rate to the market exchange rate the ING PPP Index or the ING3Pi.

Based on our latest shopping trip, which took place at the end of 2011, the won is neither under- nor over-valued. Instead, the market won-dollar rate looks fair. The standardized shopping basket cost 219,084 won in Korea and 186.79 dollars in the United States, implying a PPP won-dollar rate of 1,172 (219,084/186.79). The market won-dollar rate at the time was 1,148. These imply an ING PPP index of 102 (1172/1148*100), indicating the market won-dollar rate is 2 percent over-valued.

This is a surprising. Alternative measures find the won under-valued, significantly in some instances. For instance, The Economist magazine’s famous Big Mac index puts the won’s under-valuation at 24 percent. The Big Mac index calculates a currency’s relative value based on the price of a McDonalds’s Big Mac. The latest data were published in the January 12, 2012 issue of the magazine. The price of a Big Mac in Korea was 3,700 won. Its price in the United States was 4.20 U.S. dollars. At the time the prevailing won-dollar rate was 1,159. These imply a Big Mac index of 76 ((3700/4.2)/1159*100).

Calculations by the OECD indicate the won is 18 percent under-valued. The organization produces monthly comparative price levels that are similar to the ING3Pi and the Big Mac indexes. However, rather than visit the supermarket every month to price more than 3,000 goods and services, the OECD prices them in a benchmark year ― 2008 is the latest ― and updates successive months ― November 2011 is the latest ― using price indexes.

Yet another measure comes from the IMF, which in its 2011 Article IV report found the won real effective exchange rate was 10 percent weaker than implied by economic fundamentals. In contrast with the ING3Pi, the Big Mac Index and the OECD comparative price levels, which are based on absolute prices of goods and services, measures of the real effective exchange rate adjust the market exchange rate for changes in purchasing power as measured by broad price indexes, typically the CPI, the WPI or unit labour costs. Over- or under-valuation typically is measured in relation to a period when the real effective exchange rate was in equilibrium and holding steady.

That the ING3Pi gives such a different result for the won than the other relative value measures makes us suspicious. One possible explanation is that the cost of the shopping basket in Korea was inflated by a couple of products ― meat and cooking oil ― whose high prices may be transitory. Were the premiums on these two items to disappear the won would be 10 percent under-valued according to the ING index. This is still only about half the under-valuation in the Big Mac OECD indexes. We expect our next trip to the Korean supermarket will produce an ING index estimate more in line with those measures.