Purchasing Power Parity
26th November 2007 | Stephen McCutcheon
Let’s say we wanted to compare the living standards of two countries. How would you do it? Clearly there’s a whole bunch of data relating to GDP and export values available, but how do you ensure that the exchange rates you use are equitable.
Currency exchange rates are great when you go on holiday, especially when travelling from a rich country to a poor country, because the ‘richer’ currency usually buys you more.
However, the ability to ‘buy more’ is precisely the reason why exchange rates are unsuitable for comparing the costs of goods internationally, because they fail to "reflect the actual purchasing power of currencies in their respective countries."
Purchasing Power Parity (PPP) take away the price advantage of being able to buy more goods in one currency than another, by making all goods the same price.
For example: Joe travels to India from Hong Kong and finds that after converting one HK dollar he receives 5.67 Indian Rupees. In the store, Joe discovers that what he can buy for one dollar in Hong Kong, he can buy for just 2.58 Rupees in India.
If Joe had used PPP rates he’d have quickly found that spending one HK dollar in India, bought him exactly the same items as spending it in Hong Kong.
PPP gets a makeover in 2005
In 2005, the World Bank undertook its most complex and accurate survey of worldwide PPP rates under the aegis of the 2005 International Comparison Program, and in doing so answered several criticisms regarding their use in calculating poverty levels.
Opponents of PPP rates argue that previous calculations were based on goods and services that the poor would never buy. Further more, because China didn’t take part in the last survey in 1993, many have stated that poverty levels for China are untrue.
The World Bank intends to release the latest figures at the end of this year, but early results for Asia and Pacific region (ICP Asia Pacific) have already proved surprising.
Both India and China took part in this survey for the first time in 2005 and early results show that that the number of people living on less than $1 per day has rocketed to 300 million in China and 800 million in India.
The reports also states that China’s economy is in fact about 40 percent smaller than previous estimates suggested using the new PPP rates.
But what does that matter?
The strength of a nation lies not in the size of its economy but in the prosperity of its citizens and having a means to measure that accurately is a much better way of comparing countries.
By analysing the prices of the goods and services as a population sees them, we can instantly measure living standards more accurately and better assess a nation’s progress.
Of the 23 countries that took part in the ICP Asia Pacific survey, China and India formed 64 percent of the total GDP, but had a ranking of only 15 and 17 when comparing GDP per person values. All measurements based on one HK dollar.
The report also compared the living standards between nations by measuring the ‘actual final consumption of households’ (AFCH) in each one.
Basically AFCH calculates the total consumption of a household from what residents purchase and the total amount of income they received from the Government (e.g. for health and education).
Hong Kong, Taipei (Taiwan) and Singapore had the highest living standards, whilst China came in 16th and India came 18th.
China may well soon become the world’s number one economy in terms of size but it will take another 16 years before its citizens achieve an acceptable standard of living worth writing about and another 30 years before it catches up with economies like Hong Kong.
Another interesting statistic relating to China was its Gross Fixed Capital Formation value which means in English, the total amount of money spent on infrastructure calculated per person.
In this regard, given China’s size and population this value was never going to be high, but it needs to be if China wishes to claim the status as a developed country. At present, China can claim 10th place behind, Iran, Bhutan, Thailand and Malaysia.
What this report shows is just how far developing countries like China and India have to go before we can even begin to consider them in the same realm as the world’s top performing countries.
When we hear statistics like China will be the number one by 2027, we imagine a state of development on par with America today, yet that reality is far from true, and many accounts still stands far in distant future.
Economies in the West and the Asian Tiger economies have living standards that most Chinese can only dream about at the moment and the sooner China concentrates its developmental efforts on her people, the sooner they will get there.
- PRC, India Lagging in Economic Well-being, Standards - Asian Development Bank (ADM), (31 July 2007)