Extracting Meaning from PPP

 

“An alternative exchange rate – the purchasing power parity (PPP) conversion factor – is preferred because it reflects differences in price levels for both tradable and non-tradable goods and services and therefore provides a more meaningful comparison of real output.” – the World Bank

 

Headquarters of the World Bank in Washington. We have it on good authority that the business of ending poverty is quite lucrative for its practitioners (not least because employees of multilateral organizations such as the IMF and the World bank have to pay no taxes whatsoever on their income – and the perks certainly don’t end there). A number of long-serving employees of the institution we have met over time have struck us as quite cynical and not particularly convinced that their efforts in developing countries were achieving much (and it was not for lack of trying). That is of course not the official line and merely represents anecdotal evidence based on a limited sample size. Experience tells us though that we should not dismiss such evidence out of hand – especially not if it rings true. The agency’s views on PPP are a sign that its economists probably don’t get out much. [PT]

Photo credit: Simone D. McCourte

 

As time has gone by, people have increasingly chosen to compare the economies of different nations based on purchasing power parity (PPP) rather than nominal exchange rates. PPP provides some interesting information about economies, but when it comes to the larger issues at play, I will put forth a case in the following that it is nominal exchange rates that are of real significance.

It is also erroneous to expect that nominal exchange rates will move toward convergence in the long-term, i.e., toward equalizing the prices of superficially identical baskets of goods and services as reflected in the PPP measure.

 

The Big Mac Index published by the Economist magazine, which purports to represent a simple, informal measure of purchasing power parity. [PT]

 

Let us define these two terms first. The nominal exchange rate is what the market offers you, but the PPP rate adjusts for differences in the price of a selected basket of goods and services.

The Economist has its own measure, the Big Mac Index, as an informal PPP measurement. If a burger in the US is priced at US$5.28 at current exchange rates and in India at US$2.82, the US dollar (USD) is held to be 87% overpriced compared to the Indian Rupee (INR). Based on a basket of goods — intended to reflect real PPP — the USD is 287% more expensive than the INR (or so it is claimed).

While the huge difference between the Big Mac Index and real PPP might lead one to dismiss the Big Mac Index as useless, important information is hiding there: As countries like India go up the value chain, the seeming undervaluation of their currencies starts to disappear. In other words, their price structure is such that the more complex products are, the more expensive they are on a relative basis.

 

Value Added by McDonald’s

One may well contend that even low value-added products from countries like India — such as vegetables and poultry  —  are only seemingly cheap, as their quality has been hugely compromised. As you read the following consider whether you would be prepared to pay 287% more if you could be reasonably assured about the quality of chicken and vegetables.

McDonald’s offers a huge value-add from an Indian perspective. A McDonald’s restaurant costs between $1 million to $2.3 million. An informal Indian restaurant can be up and running on a roadside for a few hundred dollars, often not even that. Such an Indian restaurant will also pay a fraction of what McDonald’s India pays in wages.

 

A McDonald’s restaurant in Mumbai… the company enjoys a great deal of success in India. Its menu is tailored to Indian tastes: some 40% of it are vegetarian, and it lacks beef and pork recipes (which by itself makes Big Mac comparisons slightly dubious). [PT]

Photo credit: Frank Bienewald

 

When McDonald’s, Pepsi, and Coke came to India, I quickly shifted my preference to them, despite my dislike of fast food. Just the savings in medical bills made McDonald’s much cheaper than seemingly cheap Indian roadside restaurants. Even  expensive high-class restaurants in India — with prices as high as those in the West — prove expensive when their low standards of hygiene are taken into account.

 


Indian roadside food of questionably hygienic merit adds great value to fast food made by McDonald’s – whose franchisees have to comply with uniformly high standards which are strictly enforced all over the world. [PT]

 

Let us go down even lower in the value-chain, to see if India does become cheaper. The cost of vegetables in India can easily make the USD look expensive. Superficially a PPP over-valuation of 287% of the USD does look like a legitimate proposition.

But there is a catch. Indian vegetables are often washed and grown using sewage water, and chickens are overdosed with antibiotics. If one adds health cost and transaction costs (the latter include the time and effort wasted on searching for good produce), the INR starts to look a lot more expensive relative to the USD.

 


An Indian merchant of legumes gives his salads-in-waiting a thorough wash  – in what looks like somewhat less than appetizing water. [PT]

 

A fish market in Hyderabad that is evidently not exactly the most salubrious seafood trading post in the world. It is probably best avoided, so as to skirt whatever maladies are likely propagating from there. [PT]

 

Some vegetable farmers are a tad too inventive in their efforts to ensure that their produce retain its sales-worthy looks until well after its due date. It is worth noting that inflation is fingered as one of the culprits inspiring these practices. [PT]

 

Hellish Bus Rides and Schedule-Challenged Trains

What about public transportation? A bus ride might cost $0.50 in India compared to $2.50 for a similar distance in the US. But so what? I never use the bus in India, which is often driven by an untrained madman, is crowded, stops for everyone waving at it, takes forever to go from one place to another, is obnoxiously filthy, and is unsafe with metal parts sticking out.

When in India, I must take the taxi, which costs more than riding a bus in the US. Despite this, the value of a taxi in India is a lot less than that of a bus in the US. Due to India’s traffic, it takes a lot longer to take me to my destination, and the noise and chaotic conditions keep me from making use of my time to read or to listen to something while I am riding a taxi.

 

An escapee from a mental asylum masquerading as a bus driver in Kolkata – caveat everybody crossing his path… [PT]

 

Similarly, it is impossible to compare Indian trains with European trains. While I would take a train in Europe, but I almost never do so in India. In order to get a seat at all, one must make reservations months in advance in India.

Trains are always late, often by many hours, making it impossible to plan around them. One must compare taking a long distance taxi or a flight in India to taking a train in Europe. India ends up becoming much more expensive.

It is easy to stay in basic hotels while traveling in Canada or Europe. Irrespective of where one stays, one can by and large expect clean bathrooms and fresh sheets. That isn’t the case in India, where one has to stay in much higher-class hotels, and even then cannot be entirely sure about the quality of the basics. It is no wonder that most middle class Indians consider it cheaper to go abroad for reasonably convenient vacations.

 

Gently Teasing and Costly Solna Mimicry

It is in higher value-added products that the reality become more apparent in objective terms though.

As a child, I used to work with my dad at his printing company. Thirty five years ago, we replaced our troublesome USSR-made printing press with a Swedish machine, the Solna. In those days I did not even know yet what a TV was. Our experience with technology was close to negligible.

I fell in love with the Solna. It seemed to have a heart and a mind of its own, capable of absorbing and compensating for human errors. Setting it up for a new printing job was a breeze compared to what we used to experience with our USSR-made machine. Once it was set up for printing, it did its job without a hiccup.

 

Behold the mighty Solna 425+, ready to spring into action and mark dead trees with letters and images. [PT]

Photo via pressdepo.com

 

The location and design of every cog and connection seemed to have been well thought-through. One could dismantle a portion, and unlike what used to happen with our previous machine, that portion would slide back into place with precision and a satisfying click.

 

The Solna in action (we bought a single-color version of this machine in the early 1980s).

 

A year after we had bought the Solna, we were invited to see a Solna look-alike that was manufactured in Delhi. It was a counterfeit. The real Solna and the Indian-made machine looked so much alike that apart from the superficial polish, it was hard to find a difference at first. Every cog was interchangeable.

We were able to buy the Indian machine for a fifth of what we had paid for the original Solna. My personal Solna Index seemed to indicate that the Swedish Krona (SEK) was approximately 400% more expensive than the INR. I couldn’t have been more wrong.

The Indian machine started giving us small problems from day one. Initially, these were very innocent, isolated issues. A nut would come off, or a thread of a gear would break. Alas, when one deals with thousands of moving parts, such problems soon compound.

Despite our best efforts and hoping that after changing a few parts it would actually work just like a Solna, it never did. The Indian-made machine ran for no more than a quarter of the time, while we still had to pay salaries and fixed costs. The machine was rapidly proving to be much more expensive than the original Solna.

We sold the Indian machine for scrap a year later. Ironically, today – some 35 years later – the Solna machine we bought is still running. In a few years time, when all life has been extracted from it, it will be sold — not for scrap, but for its parts. When all of this is added up, my own revised Solna Index shows that the SEK is not 400% more expensive than the INR, but actually much cheaper.

It is a no-brainer that if the Indian manufacturer had tried to make his machine meet the quality standards of the real Solna, his product would have been much more expensive than the real thing.

 

Using PPP Properly

A superficial look at a comparison between PPP and nominal exchange rates convinces manufacturers and service providers in the West to move their production centers to developing countries. They often get badly burnt, but political correctness stops them from naming the key reasons for others to understand. The cost structure of many poor countries — when one adds their very low labor costs with extremely low quality and meager productivity — is actually higher.

The PPP measure can help one to imagine and conceptualize several aspects of different societies, but by no means does it indicate that PPP and nominal exchange rates will merge over time. If vegetables are no longer grown using sewage water, the cost of vegetables in India will rise exponentially, and will probably go much higher than in the US.

Having visited almost 80 countries and having lived in 7-8, I have mostly found that as a package, contrary to what the PPP measure conveys, poor countries tend to be more expensive than rich ones. Exceptions do of course exist.

For example, countries like Thailand, the Philippines, Malaysia, Vietnam, and China are letting my USD go further, although I still have to apply a discount for negative externalities such as crime in the Philippines, and pollution in all these countries.

 

The Philippines may be rife with crime, but no-one can accuse the government of mollycoddling criminals, judging from their accommodations. Meanwhile, over in Beijing, breathing can occasionally prove to be quite a challenge. [PT]

 

I find the PPP measure most helpful when comparing rich countries. Switzerland is 97% more expensive than Japan based on the Big Mac Index, and 45% based on real PPP. Hong Kong and Taiwan are also very cheap compared to other developed countries.

Instead of using the PPP measure to imagine a convergence of rich countries with poor ones and hence expect an eventual profit, it might be more useful to bet on the possible convergence between rich countries, which is the reason I like HK$ and Japanese Yen. The situation is similar with the Singaporean dollar and the South Korean won.

To what extent can the expensive CHF converge with the USD? I am reminded of a recent coffee-shop experience in Zurich, where the barista ran after me when she spotted a stray droplet on the side of my cup. She wanted to give me a new cup. In most other developed countries, in a similar situation, the barista would have done nothing.

The value of such attention to details might not be reflected to a noteworthy degree in the perceived value of a cup of coffee, but it is reflected in the quality of higher value-added products. Often people are indeed prepared to pay a multiple for Swiss products.

While Switzerland might look expensive, attention to detail and high quality gives it an unbridgeable, superlative advantage, which might justify much of the currency’s seeming over-valuation in PPP terms.

 

CHF vs. JPY – for many years the two currencies were closely correlated, but a fairly wide gap has opened in their relative performance vs. the USD since 2013. A previous gap in favor of the yen at the turn of the millennium was eventually resolved by re-convergence. [PT]

 

Of course, a Japanese barista would very likely have done the same thing the Swiss one did. So, why is the CHF so much more expensive than Japanese Yen? PPP and nominal exchange rate differences should be used to ask questions rather than perform simplistic linear comparisons. ­

 

Charts by: Economist, StockCharts

 

Editing and chart & image captions by PT

 

Jayant Bhandari grew up in India. He advises institutional investors on investing in the junior mining industry. He
writes on political, economic and cultural issues for several publications. He is a contributing editor of the Liberty magazine. He runs a yearly seminar in Vancouver titled Capitalism & Morality.

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • The Hollow Promise of a Statist Economy
      Brainwashed by Academe Not a day goes by that doesn’t supply a new specimen of inane disclarity.  Muddy ideas are dredged up from tainted minds like lumps of odorous pond muck.  We do our part to clean up the mess, whether we want to or not.   No longer in demand: famous Enlightenment philosopher John Locke (1632–1704), who is widely considered the “Father of Liberalism” (classical liberalism, that is). [PT]   These days, individuals, who like John...
  • The Great Debasement - Precious Metals Supply and Demand
      Fiat Money Woes Monday was Labor Day holiday in the US. The facts are that the euro lost another 1.4%, the pound another 1.1%, and the yuan another 0.9% last week.   Assorted foreign fiat confetti against the US dollar – we have added the Argentine peso as well, as it demonstrates what can happen when things really get out of hand. [PT]   So, naturally, what is getting play is a story that Bank of England governor Mark Carney said the dollar’s influence...
  • Hong Kong - Never the Same Again
      Freedom Rock Hong Kong ranks among the freest societies in the world. Not only economically, but socially it is a very liberal place. It was marinated in British ways until 1997, much longer than Singapore and other colonies. Then China took it over as a special administered region, which according to the agreement with the UK meant that it was only nominally to be under Chinese control for the next 50 years. It was possibly the only colony in which a vast majority of citizens did not...
  • Suffering the Profanity of Plentiful Cheap Money
      A Case of Highway Robbery What if the savings in your bank account lost 55 percent of its value over the last 12 months?  Would you be somewhat peeved?  Would you transfer some of your savings to another currency?   USD-ARS, weekly. For several years the Argentine Peso has followed a certain pattern: it declines mildly, but steadily, with little volatility for long time periods, and then spikes in crash waves whenever a crisis situation comes to a head. In early 2011, it...
  • Don’t Be Another Wall Street Chump
      The Future and the Past Securities and Exchange Commission Rule 156 requires financial institutions to advise investors to not be idiots. Hence, the disclosure pages of nearly every financial instrument in the U.S. are embedded with the following admission or variant thereof:   “Past Performance Is Not Indicative of Future Results”   “Buy and hold”... “The market goes always up”... “No-one can time the market”... “Buy the dip” “With what? You...
  • A Wild Week - Precious Metals Supply and Demand
      Paying a Premium for a Lack of Default Risk The price action got pretty intense last week! The prices of the metals were up Monday, Tuesday, and Wednesday. But Thursday and Friday, there was a sharp reversal and the silver price ended the week below its close of the previous week.   The net speculative position in gold futures has become very large recently – the market was more than ripe for a shake-out. [PT]   Silver made a round trip down from $18.35 to...
  • Will the Nikkei Win the Next Olympic Games?
      Listless Nikkei On 24 July 2020 the Olympic Summer Games will begin in Tokyo, the capital of Japan. Olympic Games and Soccer World Cups are among the largest sporting events in the world.  Do you perhaps also think that these events may affect the performance of local stock markets?   Olympic Summer Games 2020 – official logo (left), and a fan-made logo (right) by designer Daren Newman [PT]   Let us examine whether and in what way such major sporting events impact...
  • The Weird Obsessions of Central Bankers, Part 3
      Inflation and “Price Stability” We still remember when sometime in the mid 1980s, the German Bundesbank proudly pointed to the fact that Germany's y/y consumer price inflation rate had declined to zero. It was considered a “mission accomplished” moment. No-one mentioned that economic nirvana would remain out of sight unless price inflation was pushed to 2% per year.   CPI, annual rate of change. During the “stagflation” period of the 1970s, Congress enacted the...
  • The Weird Obsessions of Central Bankers, Part 1
      How to Hang on to Greenland Jim Bianco, head of the eponymous research firm, handily won the internet last Thursday with the following tweet:     Jim Bianco has an excellent idea as to how Denmark might after all be able to hang on to Greenland, a territory coveted by His Eminence, POTUS GEESG Donald Trump (GEESG= God Emperor & Exceedingly Stable Genius). Evidently the mad Danes running the central bank of this Northern European socialist paradise were...
  • The Weird Obsessions of Central Bankers, Part 2
      The Negative Interest Rates Abomination Our readers are probably aware that assorted central bankers and the economic advisors orbiting them occasionally mention the “natural interest rate” (a.k.a. “originary interest rate”) in speeches and papers. It is generally assumed that it has declined, which is to say, time preferences are assumed to have decreased.   This is actually an understatement...   Although interest is generally associated with money, the...
  • Why Are People Now Selling Their Silver? Precious Metals Supply and Demand
      Big Moves in Silver Last week, the prices of the metals fell further, with gold -$18 and silver -$0.73. On May 28, the price of silver hit its nadir, of $14.30. From the last three days of May through Sep 4, the price rose to $19.65. This was a gain of $5.35, or +37%. Congratulations to everyone who bought silver on May 28 and who sold it on September 4.   The recent move in silver [PT]   To those who believe gold and silver are money (as we do) the rising price...

Support Acting Man

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!