May 9th 2014

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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.