Multinational Financial Management, Importance of Computation of PPPs - Coursework Example

ultinаtiоnаl Finаnсiаl Маnаgеmеnt Student’s Name (Institution) (Course Code) Da Introduction PPPs are rates which are used in the conversion of currencies that makes purchasing power of two currencies of various countries to be equal (Adjasi and Biekpe, 2006). This is resulted when there is elimination of price differences between two countries. The simplest definition of PPPs is just a mere price relative that indicates the proportion of prices of domestic goods of various countries. The computation of purchasing power parity ensures there is an accurate estimation of what exchange rate between two countries would be so that it equates that of the two countries’ currencies (Muellbauer, 2007). The conversion is done between Singapore and USA so that to determine the country with high currency value. Importance of computation of PPPs This computation of PPPs is very important in improving the quality of international comparison of purchasing power of money by the use of exchange rates. Due to fluctuating nature of market exchange rates, the measurement of GDP of two countries that has the same GDP may vary when measured in their own home currencies (Muellbauer, 2007). It is likely to have higher GDP in one country in a given years and vice versa. PPPs can be estimated annually using GDP of the two countries. To achieve this the below formula is used PPP rate x,i= PPP rate X I .(GDP defX,i/GDP def X,b PPP rate U,b .GDP def U,i/GDP def, U,b Where PPPrateX,i = PPP exchange rate of country X for year i PPPrateX,b = PPP exchange rate of country X for the benchmark year PPPrateU,b = PPP exchange rate of the (US) for the benchmark year (equal to 1) GDPdefX,i = GDP deflator of country X for year i GDPdefX,b = GDP deflator of country X for the benchmark year GDPdefU,i = GDP deflator of the US for year i GDPdefU,b = GDP deflator of the US for the benchmark year Computation of PPP from 2011 to 2014 using 2010 as the benchmark period YEAR PPPrate PPP rate US GDPdef, Singapore GDP US GDP def Sng/GDP Sing b GDPUSA, I/GDP def US b PPP rate sing Singapore 2010 0.7 1 101.2 101.95 1 1 0.7 2011 0.7 1 101.2 103.92 1 1.019323198 0.713526238 2012 0.7 1 102.3 105.82 1.010869565 1.037959784 0.734469369 2013 0.7 1 102.3 107.3 1.010869565 1.052476704 0.744741668 2014 0.7 1 102.5 108.65 1.01284585 1.065718489 0.755585984 The result obtained when purchasing power parity between the currency exchange rate of USA and Singapore has a slight deviation. In 2011, the purchasing power parity is not equal to the exchange rate as the ratio between the US and Singapore is not equal. The purchasing power parity between US dollar of 1.0 and 0.755 Singapore pound are the same but not exact (Akinboade, 2006). This is a significant sign that the purchasing power of the Singapore gains more purchasing power than US. For Singapore to buy a single commodity of a product, it has not to spend $0.755 to get the same number of goods in USA (Makina, 2006). It is therefore significantly shown that the prices of goods in Singapore are relatively expensive. The same problem is found from 2011 to 2014 as there is an increase in ppps. Year PPP EXR 2011 0.713526238 1.604123. 2012 0.734469369 1.584877 2013 0.744741668 1.564768 2014 0.755585984 1.647701 In relation to the result obtained the currency of Singapore tends to be overvalued against the US dollars (Adjasi and Biekpe, 2006). This is because there are high PPPs as compared to exchange rates. The overvaluation of Singapore currency is caused by the below factors. Inflation The overvaluing of Singapore currency is caused by low inflation rate in Singapore than US. This makes its export to have higher competitive advantage than US (Makina, 2006). This causes an increase in demand in Singapore currency than US when buying goods. This makes Singapore to low competition for foreign goods making citizen of Singapore to use less imports. The fall in inflation makes Singapore currency to appreciate in value hence making it to be overvalued. Interest Rates UK also has higher interest rates than USA. This makes its currency to be more attractive for many people to deposit money in Singapore than USA (Makina, 2006). This enables Singapore to have a higher rate of return from banks than USA. This increases demand for its currency and as a result increases its value. Speculation There is also a speculation that the value of Singapore currency is expected to rise in future. This makes people of different countries to demand more of UK currency to make profit (Akinboade, 2006). This increase in demand increases the value of sterling pounds. The sentiments in the market therefore increase the value of Singapore currency. Relative strength of other currencies The value of Singapore currency increases due to the fact that market is worried about the currency of USA. This makes Singapore currency to appreciate over time from 2010 to 2014. Balance of payments The increase in value in Singapore currency can also be caused by the influence of balance of payment. This company has no deficit in its current account which means that it has more exports than imports (Adjasi and Biekpe, 2006). This deficit is financed by surplus on the capital account. This is therefore able to increase the value of Singapore currency. Government debt I also think that the Government of Singapore has no debt. This increases the confidence of the market that this country cannot default on its debt (Akinboade, 2006). This gives the Singapore to sell more bonds to many investors and as a result increases the value of exchange rates. The confidence that the investors has about Singapore is higher than that of US and this increases the value of Singapore currency. Problems encountered by Singapore as a result of overvalued currency The problems which overvalued currency of Singapore cause is the increase in export but a decrease import prices (Muellbauer, 2007). This makes it to depress domestic demand and make most people to buy import goods. This is a threat to domestic industries since the cost of domestic goods will be high. Singapore also experiences a great problem when there is sluggish growth (Akinboade, 2006). This is because when the state of economy of Singapore is at boom, high currency value can be used to solve the problem of inflationary pressure while in the case of recession it cause the problem of deflationary pressure. Possible Solutions to overvaluation of Singapore currency To solve the problems faces by Singapore due to overvaluation, it is recommended for the country to depend on deflationary policies such as an increase in taxation and reduction in spending so that there is a reduction in consumer spending on imports. Top of Form Limitations to Using Purchasing Power Parity The use of PPP is not more accurate and it is only need to be used for a long term analysis. To achieve the result of PPP, it may take a very long time since making PPP to be equal to exchange rate takes a very long time (Adjasi and Biekpe, 2006). There is also another problem of PPP is that it assumes that goods have ready market which is not true. This is because it ignores existence of tariffs, quotas and taxes (Makina, 2006). To effectively obtain accurate result, there arte other factors which need to be taken into consideration and they include interest rates, inflation and economic releases and when it is used alone it may give a wrong picture of the economy. Conclusions Singapore has overvalued currency which shows that its market rate is above the purchasing power parity. This makes its exported goods to be very expensive than imported goods. The only benefit is it has due to overvalued currency is that there is a mechanism to control inflation which also produce a positive effect on competitiveness. The effect of overvalued currency in Singapore makes the cost of domestic goods to be very high as compared to imported goods. This makes it difficult for foreigners to buy Singapore goods since they have a currency of low value relative to that of Singapore. It is therefore recommended for Singapore Government to use deflationary polices such as taxation and reduction in consumer spending to reduce its value. Bibliography Adjasi, C and Biekpe N (2006), ‘Stock Market Development and Economic Growth: The Case of Selected African Countries’, African Development Review, Vol. 18, No. 1, pp. 144– 61. Akinboade, O. (2006) The Validity of the Purchasing Power Theory for South Africa: A Cointegration Approach’, African Finance Journal, Vol. 8, No. 2, pp. 1–12. Makina, D (2006), ‘Mean Reversion and Structural Breaks in Real Exchange Rates. South African Evidence’, Applied Financial Economics, Vol. 16, No. 4, pp. 347–59. Muellbauer (2007). Review of Monetary Policy in South Africa since 1994’, Journal of African Economies, Vol. 16, pp. 705–44. Read More