May 9th 2014 PrintShare

Asia's purchasing powers In late April the World Bank's International Comparison

Programme (ICP) published new data that highlighted that the

shift of economic weight from developed to emerging markets is

even more rapid when economic activity is measured at

purchasing power parity (PPP) exchange rates. Leading the way

were Asia's big three emerging economies (China, India and

Indonesia), which in 2011 had ranked as the world's second-,

third- and tenth-largest economies respectively, according to the

ICP's calculations. The new numbers suggest that China will

supplant the US as the world's biggest economy in 2014 on this

measure, but there are many reasons to treat the data cautiously.

The idea that China will overtake the US as the world's biggest

economy this year has provided fuel to doomsayers in the latter

country worried about the declining influence of the US on the global

stage. Previously, based on the last version of PPP exchange rates

provided by the ICP in 2005, it had looked like China would surpass

the US only in 2019. Within Asia, India has overtaken Japan to

become the world's third-largest economy measured under PPP

exchange rates. When the ICP made its last revision in 2005, it had

ranked India's economy as only the 10th-largest in PPP terms.

Is China really the world's biggest economy?

It is important to note that the ICP has not uncovered new economic

activity. The economic "power" of countries like China and India has

not risen: global economic transactions are conducted at market

exchange rates, not PPP ones. The Economist Intelligence Unit

forecasts that China's GDP at market exchange rates will reach

US$10.4trn in 2014, but this is still less than 60% of the size of the US

economy, at US$17.6trn.

In practice, the use of PPP exchange rates tends to boost the apparent

size of developing economies relative to wealthier ones. This reflects

the fact that a given amount of US dollars converted at market

exchange rates will buy more goods and services in many emerging

markets than it will in a developed country. Nonetheless, the task of

measuring economic activity at PPP exchange rates remains very

difficult. The theory behind the idea is simple: economic output in a

country includes many goods that are not tradeable across borders, so

using market exchange rates to measure GDP can be misleading if the

prices of non-tradeable goods are systematically different. Given that

non-tradeable goods, such as restaurant meals or haircuts, are often

labour-intensive, the low wages in emerging markets typically mean

that this is the case. Furthermore, market exchange rates can also

fluctuate violently from year to year, distorting comparisons between

economies. The system of PPP exchange rates seeks to produce a way

of comparing the prices of a basket of goods and services between

countries to produce a measure of performance that counts the quantity

of goods and services produced undistorted by such price differences.

There are many flaws in the idea of PPP, however. Perhaps the most

important is that finding a basket of goods and services to compare

prices between countries is virtually impossible. Countries produce

(and consume) very different types of goods and services, and

differences in quality are hard to take into account. Food in China may

be cheaper than in the US, but consumers in the US do not have to

worry to the same extent about food safety because part of the higher

price they pay goes towards maintaining a stricter regulatory and

monitoring regime. Compounding these concerns, there have been

sharp shifts in the PPP exchange rates used by the ICP between 2005

and 2011, which raises questions about the supposed greater stability

of PPP exchange rates.

So what use is PPP?

The problems involved in using PPP exchange rates mean that many

economists consider market exchange rates the only appropriate

measure to use when ranking the sizes of different economies around

the world. Certainly, for companies wanting to assess business

opportunities, market exchange rates are the ones that matter. The

Chinese government appears to share this view, and refused to co-

operate with the ICP in its work (raising further questions about the

data used for China). The Chinese administration's decision may have

been driven in part by a concern that the resulting figures might be

used by those arguing that China's growing economic weight means

that the country should do more to address global concerns such as

climate change.

PPP exchange rates are best used to compare and contrast output per

head in various countries, rather than to rank economies in terms of

their size. The economic strength of China, India and Indonesia stems

partly from their large populations. They are much weaker in terms of

output per head, which stood at US$9,202, US$4,960 and US$8,389

respectively in 2011 under the newly updated PPP figures. This

compares with US$51,605 in the US and a global average of

US$13,258.

Pointing to undervalued currencies

A further use of PPP exchange rates is to gain an idea of which

currencies are undervalued. India's and Indonesia's shares of the world

economy under PPP measurements, at 6.4% and 2.3% respectively, are

around double their shares when measured by market exchange rates.

(Both countries have experienced a significant depreciation of their

currencies against the US dollar since 2011, which will only have

widened the ratio). This suggests that prices for goods and services

that are not traded across borders are very cheap in India and

Indonesia, even compared with those in many low-income nations in

Africa. The price level for government expenditure in Indonesia was

particularly low compared with other GDP expenditure components at

PPP exchange rates, suggesting that government expenditure could be

a more effective way to reduce poverty, which remains endemic in the

country. By contrast, the price level for fixed capital formation in India

was high. This could reflect a number of factors, including problems

such as graft that raise the cost of investment.

Emerging markets come to dominate the global economy

The new PPP exchange rate data have many problems and can be

easily misconstrued. Nevertheless, whatever the merits of the figures,

they have again drawn attention to a secular trend that is evident

whether using PPP or market exchange rates. Emerging markets are

accounting for a growing share of global economic output, and Asia's

largest economies are leading the charge. Companies that wish to

succeed in this global environment will need to follow the money.