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Saturday, April 1, 2006
Big Mac and price parity

In 1986 the Economist invented a guide to help determine whether currencies were at their ‘correct’ level. The guide was based on a standardised product that is available in approximately 120 countries worldwide, the McDonalds Big Mac burger. What started as an interesting and light-hearted guide to currency valuation has since turned into the widely acclaimed Big Mac Index (BMI).
An interesting aspect of the BMI is that it provides a quick reference to what a dollar should be in other countries. Prices in poor countries tend to be lower, so for example, an American who spends his dollars in South Africa can get a lot more for his money than he would in America.
It is therefore misleading to convert South African wages into dollars at market exchange rates. Similarly, the average haircut in the US is far more expensive in rand terms than the average haircut in South Africa. This is true for all non-tradable goods and services in developing countries. This has some major implications for the way in which we view the growth of developing countries. For instance, converting a developing country’s GDP into dollars at market exchange rates will significantly understate the true size of its economy and its living standards. 
But how do we know how much more a dollar will be worth in a country like South Africa? For this we need a better method than simply converting outputs at current exchange rates. A better method, known as purchasing power parity (PPP), takes into account price differences across economies. For example, a Big Mac burger costs $3.00 in the US and R13.95 in South Africa. However, at an exchange rate of, say, R6.10 to the dollar a Big Mac should cost about $2.29 (R13.95/R6.10). Given that the Big Mac price in the US is $3.00, the implied purchasing power parity of the dollar is R4.65 (R13.95/$3.00). But assuming the current exchange rate of R6.10, suggests the rand is undervalued by about 24%. Similarly, if you do the same calculations for all the other developing countries you will find that their currencies are also undervalued. China has the most undervalued currency relative to the dollar at 58%. At the other end of the scale is Switzerland, which has the most over-valued currency at 69%.
China is accused of keeping its currency artificially low so that its firms can sell goods cheaper in foreign markets. However, China is also a very large importer, especially of the machinery and raw materials with which to produce its export goods. If its currency is under-valued it means that the input costs of the Chinese manufacturers are being raised artificially, reducing their competitiveness. There is always another side to the story. Low-cost clothing imports from China may make life difficult for their SA competitors but low-income and unemployed South Africans are able to clothe themselves at low cost and lead a more dignified, warmer and comfortable life.
Charles Dumas, an economist at Lombard Street Research has said that, “... even if a Chinese loaf of bread is a quarter the cost of a loaf in America, it uses the same amount of flour”. Chinese manufacturers are said to be able to sell at such low prices because they pay their workers much lower wages than workers in other countries. However, we find that a Big Mac costs them about $1.27, indicating that the workers can buy almost 150% more than American and 80% more than South African workers with the dollar and rand equivalents of their wages. So a straight currency conversion of their wages does not tell the whole story either.
People see development in developing economies in the form of buildings being erected, roads being built, and new advances in telecommunications, yet developing countries contribute relatively little to total global output when converted at market exchange rates.
Take China for instance, over the past 20-odd years of reform and opening up, it has experienced sustained, rapid economic growth, with an average annual growth rate of GDP in the 1990-2002 period reaching 9.7%, and the total GDP volume exceeding 10 trillion Yuan in 2002. When this rate is converted at market exchange rates, China ranks sixth of the global economies. However, when converted using the PPP method, China jumps to second place, ahead of Germany, the UK and France and accounts for roughly 13% of world output. India moves from eleventh to fourth place, and Brazil, Russia and South Korea are then ahead of Canada. Interestingly South Africa moves from 33rd to 21st, ahead of Switzerland and Sweden.
Another major implication of simply converting outputs using market exchange rates is that inequality figures are exaggerated. Using market exchange rates the average American is 33 times richer than the average Chinese; on a PPP basis he is ‘only’ seven times richer. This apparent magical decline in inequality is not surprising when one considers that along with rapid economic development, China’s population living in extreme poverty (defined as living on less than 1 US dollar a day) has decreased by approximately 150 million, accounting for 85% of the total poverty reduction in the East Asian region.
Bringing PPP or the BMI into comparisons of countries provides the observer with a much clearer picture of what is really happening in the world. Developing countries are not only growing much faster than rich countries, they are also demanding an increasing quantity of resources in order to do so. This is what has been driving the phenomenal increase in commodity prices in recent times despite the modest growth of developed countries.
By Jasson Urbach is a research economist with the Free Market Foundation

Copyright © Insurance Times and Investments® Vol:19.2 1st April, 2006
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