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Was the Pound really overvalued?

In recent post, I looked at whether Pound Sterling would have fallen without Brexit vote?

There was a good case to say it was overvalued, but there are a few other factors I’d like to mention.

  1. Big Mac index

According to the Big Mac index, the Pound wasn’t overvalued at all. In fact, on this narrow measure was actually undervalued.

Big mac index Pound
Source: Economist.com

pre Brexit vote June 2016 (exchange rate £1 = $1.4) 

  • Price of Big Mac UK £2.99 ($4.19)
  • Price of Big Mac $5.04
  • Pound undervalued 16%

July 2016 (exchange rate £1 = $1.31)

  • Price of Big Mac UK £2.99 ($3.94)
  • Price of Big Mac US $5.04
  • Raw index undervalued by 21%
  • Undervaluation of Pound  $5.04-$3.94 = $1.10 / $5.04 = 21.8%

October 2016 (at current exchange rate of £1=$1.22)

  • Price of Big Mac UK £2.99 ($3.66)
  • Undervaluation of Pound Sterling $1.30/$5.04 = 25.7%

Evaluation of Big Mac Index

Of course, it should be noted the Big Mac Index was started as a light-hearted guide to explaining exchange rates and purchasing power parity. The Big Mac is not necessarily reflective of the whole economy. For true PPP we need a much wider basket of goods.

Apple Macbook index

As a veggie, I don’t eat Big Macs, but I do often compare the UK and US price of Apple Macbooks. (I usually buy Macbooks in US because they are cheaper).

12 inch Apple mac book

June 2016 – £1=$1.4

UK £1,040 ($1,456) US price $1,299.

June 2016, Pound overvalued by 10%

October 2016 – £1=$1.22

  • UK £1,040 ($1,271) US price $1,299.

This is the first time, I’ve noticed it is cheaper for me to buy an Apple Macbook in the UK rather than buy in US.

In October 2016, the Pound is slightly undervalued at 2%

Evaluation of Apple Macbook index

One obvious issue with Apple Macbook index is that the price of Apple’s is influenced by different tax rates. A UK macbook includes 20% VAT rate. In US you have to add on state sales tax. So excluding sales tax the Pound wasn’t overvalued.

Current account deficit

The best case for the Pound’s overvaluation was the size of the current account deficit

UK-current-account-from-2001However, it is worth noting the different components of the current account

  • Trade in goods
  • Trade in services
  • Net investment incomes

One of the main reasons for the deterioration in the UK current account in recent years, is not a deterioration in trade in goods and services, but net Investment incomes. And this was partly due to strength of FDI into UK, and relatively higher returns on UK investment.

bop-total-primary-income-balance-as-per-cent-of-gdp
ONS

As ONS state, this decline in net foreign income is because of two factors:

  1. Rise in Foreign Direct investment in UK (which causes foreign firms to make profit on investment then send some profit back to country of origin
  2. Improved returns on UK investments compared for foreign investment. This reflects the fact the UK economy has been doing relatively well compared to Eurozone. Stronger UK economy makes UK investment more profitable, leading to more income outflows.

bop-trade-in-goods-and-services-balance-as-per-cent-of-gdp-1

Balance of trade in goods and services shows a fairly steady level, and not a huge imbalance

Overall

There was some overvaluation in Pound, but majority of the fall in Pound since the vote reflects the fundamental shift in attractiveness of UK as a place for FDI and portfolio investment.

An interesting question for next week will be whether a fall in the Pound will be successful in ‘rebalancing’ the UK economy.

See also

  • Dominance of Brexit at Coppola Comment


This post first appeared on Economics Help Blog | Economics Help, please read the originial post: here

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Was the Pound really overvalued?

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