As manufacturers continue to assess their business opportunities overseas – both selling into foreign markets and setting up shop there – they’re increasingly having to get in tune with regional and global growth rates, studying multi-country and cross border economic data that can determine whether or not to do business in these spots.
But before successfully wading into international waters, manufacturers need to know such things as which regions of the world are growing the quickest, which have the largest net inflows of capital, and which have the largest current account imbalances, among other things.
Manufacturers Alliance/MAPI has come out with research examining the key technical issues that users of cross-country and regional data have to be aware of in order to make accurate use of the data.
For instance, while the International Monetary Fund says so-called purchasing power parity is the correct tool for cross-country comparisons of gross domestic product, there is less certainty in the international economic community, says Cliff Waldman, an economist at MAPI.
“World Bank publications, for example, often cite global growth rates that are calculated with the use of market exchange rates,” he said.
Purchasing power parity attempts to explain movements between two countries’ currencies by changes in those countries’ price levels. In other words, the PPP exchange rate is equal to the ratio of the countries’ price levels.
“The inherent prediction in this theory – that exchange rates gravitate to the PPP level – is based on the law of one price,” Waldman said. That law says that in competitive markets, free of transportation costs and official barriers to trade, identical goods sold in different countries have to sell for the same price when their prices are expressed in the same currency.
In other words, if P(US) is equal to the dollar price of a particular commodity basket sold in the U.S., and P(EU) is equal to the euro price of the same basket in the Eurozone, then PPP predicts a dollar/euro exchange rate of P(US) divided by P(EU).
“Using PPP to compare and aggregate real GDP of individual countries removes cross-country prices difference as an issue,” Waldman says.
Why does this matter? The chart below shows the different results the two methods can deliver.
|Two measures of global GDP growth. To view chart larger, click here.|
Meanwhile, the following table shows the sharp differences between the regional shares of global GDP using both PPP and market exchange rates. Using the PPP system, the 2000 global GDP share of the advanced economies would be 57 percent, versus 79.9 percent using market rates. The world GDP share of developing countries would have been 37.2 percent using PPP versus 17.9 percent using market exchange rates. Waldman notes that since developing economies tend to grow faster than mature economies, PPP produces a higher global growth estimate.
|2000 global GDP shares under market exchange rate. To view chart larger, click here.|
So, which method is preferable? Waldman said the IMF studied both methods in the early 1990s and concluded that PPP was the better weighting method for comparing real GDP across borders, and calculating regional and global growth rates. The PPP method is more stable, showing less short-term fluctuation than market exchange rates.
PPP rates are also believed to provide a more balanced estimate of the relative global GDP shares between rich and poor countries, as market exchange rates only adjust prices of tradable goods. Non-tradable goods, primarily services, are relatively more expensive in rich countries.
“Using an adjustment standard that equilibrates only the prices of tradables produces a global growth estimate that tends to significantly overstate the share of world output that comes from the industrialized countries,” Waldman said.
Finally, the economist says while market exchange rates are seen as a reasonable short-term proxy for the purchasing power rate, that’s contradicted by “a rather substantial body of evidence.”
“Apparently, while the law of one price holds for a subset of internationally traded goods, it is often violated for manufactured goods.”
Waldman sees the biggest shortcoming of PPP in the error-prone process of calculating country PPPs, especially in developing economies, where the needed benchmark studies on price trends are often unavailable or difficult to produce.To comment on this story, email us at: [email protected]