We showed earlier this week that, despite the rand’s large appreciation over the last year, the Big Mac Index still implies a 45 percent undervaluation. But the Big Mac is just one good. Is the ZAR still undervalued when considering the relative prices of other goods and services in South Africa and other countries? Today’s post by Oliver Guest plots historical implied fair value estimates from a model that incorporates South African and United States inflation data. Although the exchange rate has persistently deviated from Purchasing price parity (PPP)-based estimates of its fair value, it has cycled around its PPP-implied equilibrium over the long term. At present, these estimates imply the rand is now actually below fair value. Nevertheless, it is clear from the simple PPP model that such models tend to struggle to detect mean reversion in exchange rates. As a result, in practice, fair value models generally incorporate other explanatory factors that can explain deviations from PPP.
