Purchasing Power Parity (PPP) in Forex Trading

I’ve received a rather strange spam message today from some crazy folks, explaining how messed up the global financial system (and Forex market in particular) currently is. Although it’s a mix of the laughable arguments and the paranoid conclusions of some conspiracy theory nuts, it caught my attention because one of the arguments used was the Purchasing Power Parity (PPP) between US and EU (not Eurozone but European Union for some reason). And I’ve thought that there is a lot of misunderstanding about PPP in the Forex community. I’m afraid there are too many people who know nothing about it, while there are also many traders who believe that Purchasing Power Parity is the main driver of the currency rate changes. In reality PPP is one of the great fundamental analysis tools that can be used in Forex trading among others if you know how it works.
What Is PPP?
Purchasing Power Parity or PPP is an economic theory that implies that the international currency rates should be balanced according to the relative cost of goods and services in the given countries. For example, if the basket of goods costs $1,000 in country X and the same basket of goods costs $2,000 in country Y then the PPP relation is 1:2, which means that the currency of country X should appreciate by 100% relatively to the currency of country Y. Ideally if their current exchange rate (X/Y) is 1:2, it should become 2:2. (Side note: a fun version of PPP is calculated by The Economist and is called Big Mac Index.)
Real Examples
Let’s get to more real examples. According to IMF, the nominal GDP of the Eurozone (16 EU countries that adopted the euro) was at $12,503,317 million in 2009. While the GDP (PPP) of the Eurozone was at $10,599,223 million that year. That means that the EUR/USD was overvalued by about 18% according to PPP. If we consider the average EUR/USD rate in 2009 as 1.4099 then the PPP-adjusted rate should be about 1.1948.
Another example is China. IMF lists China’s nominal GDP for 2009 as $4,908,982 million, while the GDP (PPP) is listed as $8,765,240 million, which signals about 78.6% overvaluation of the USD/CNY currency rate. 2009 average 6.8290 rate should have been 3.8236 according to the purchasing power parity.
It’s Not That Good Actually
So, why is it a bad indicator to use as the main currency rate forecast tool? First, it’s far from perfect — it has a lot of flaws in calculation and in its interpretation as the currency rates disparity (it may just signal inflation disparity rather than imbalance in the foreign exchange rates). Second, because it’s just one of many factors that influence the currency pairs. Trade balance, supply and demand, interest rates, risk aversion/hunger, political stability and other factors are affecting the currencies at a not lesser extent than PPP (and sometimes even more than it).
How To Use It in Forex Trading?
Despite its disadvantages and lack of short-term opportunities for trading, PPP can be used successfully in Forex. It’s a long-term fundamental indicator, which means that you can use it to predict the future of the currency rates by 1–2 or even more years. If you consider all the fundamental indicators in complex, PPP should be one of them and if all others are balanced the PPP can be chosen as the leading influencing factor. For example, you could go long on the Chinese yuan now and in 3–4 years you’d probably be in profit (if something horrible doesn’t happen there, of course).

If you have any questions or comments about using Purchasing Power Parity (PPP) in Forex trading, please, reply using the form below.