Misleading picture

Published : Nov 04, 2011 00:00 IST

The theories about a major shift in global economic power from the North to the South are premature because they are derived from a flawed methodology.

TWO thoughts dominate in the global financial press in these uncertain times. The first is the growing concern, even fear, about immediate economic prospects with the almost certain possibility of another major financial crisis. The euro area is apparently unable to resolve the problems of imbalance and debt in the peripheral countries, which now threaten the profitability and even viability of major banks in the core countries. The United States is so hamstrung by its complex political process that its government is unable to take any meaningful measures to prevent the economy from falling into recession or even depression. The contagion effects in the rest of the world will probably be more pronounced than they were in 2008 and 2009 since many economies that withstood the earlier crisis are financially more vulnerable now.

The second perception, which is expressed in gloomy or resentful terms in the North and in excessively confident terms in the South, relates to the shift in global economic power, which has been occurring especially over the past decade and is widely seen to have been accelerated by the crisis.

All the major global publications, whether they are from the International Monetary Fund (IMF) or the World Bank or the Organisation for Economic Cooperation and Development (OECD) or the United Nations Conference on Trade and Development (UNCTAD), have taken note of this tendency and see it as possibly the dominant process in the future. Some further argue that the downturn in the North will be effectively counterbalanced by continued growth in emerging markets, particularly in countries such as Brazil, Russia, India, China and South Africa (BRICS) .

In some recent publications, the impression is given that the shift has already occurred. The IMF's World Economic Outlook for September 2011, for example, suggests that developing countries now account for nearly half (48 per cent) of world output, more than double the share of two decades ago. According to their estimates, in 2010 the U.S. economy accounted for less than one-fifth of global output and the euro area less than 15 per cent. Developing Asia, by contrast, accounts for 24 per cent.

Described in this way, it certainly appears as if the fulcrum of global economic power is on the verge of changing or has already done so. But a closer look reveals that these estimates are all based on Purchasing Power Parity (PPP) rates instead of actual exchange rates.

The economic theory behind the use of PPP measures is that exchange rate comparisons of less-developed economies consistently undervalue the non-traded goods sector, especially labour-intensive and relatively cheap services, and therefore underestimate real incomes in these developing economies.

In some cases, this can be quite significant. For example, according to the Penn World Tables, which provide the most widely used source of information on incomes deflated by PPP, total incomes in countries with large poor populations such as India or China increased by multiples of around 2.5 with the PPP estimate, compared with the nominal exchange rate estimate in 2005. (In India, for example, the World Bank's latest PPP estimate is Rs.19 a U.S. dollar, compared with the actual exchange rate of more than Rs.48 a dollar.)

The use of PPP rates led to the grandiose statements of China becoming the second largest economy in the world or India even reaching sixth position on the global economic ladder. These conclusions are based on the assessment that our currencies command several times more goods and services than are reflected in the actual exchange rates.

However, there are some major problems with the estimates of income using exchange rates based on PPP. The most significant is that of deriving the actual price comparisons. Obviously, PPP calculations should be based on comparing the prices of identical (or at best very similar goods) in different countries, and these should in turn be the goods that are most commonly represented in total expenditure. But this is easier said than done. It is almost impossible to find identical goods that dominate consumption and investment across different countries.

So the first question is how to choose comparable baskets of goods in different countries. Currently, a representative basket of U.S. consumption is taken as the norm, which is highly problematic because of enormous differences in consumption that stem not only from cultural patterns but also from per capita income itself. It is also worth noting that in recent years, the process of goods consumed in greater proportion (such as consumer durables) by the better-off have been falling, especially relative to the prices of essentials such as food. So this too would not adequately reflect actual purchasing powers across different income groups.

The second, and even more daunting, problem is how to find the actual prices of such goods and services, and what to take as the representative price of each. This obviously has to use either existing price data or data from surveys that are constantly updated. But this is also very difficult especially in most developing countries, including very large ones.


There are real concerns about the poor and often outdated quality of the data on actual prices prevailing in different countries (including large developing countries such as China and India) that are used in such studies, which affect the reliability of such calculations. Thus, until recently, there had been no major survey or even careful estimate of prevailing prices in India and China so that the PPP estimates before 2005 have been based on very outdated evidence on prices of goods and services in these two countries.

When they were finally revised on the basis of recent surveys and fresh evidence on actually prevailing prices in the two countries, the PPP estimates in these two countries changed dramatically. The 2005 PPP-adjusted per capita income for China in U.S. dollar terms, for example, shows a 40 per cent decline compared with the 2000 estimate. This is because the new PPP for China is estimated to be around half the nominal rate, whereas the previous estimate (dating from 1993) had suggested it was only around one-fourth of the nominal rate. This downward revision of per capita income in China also adds significantly to the estimate of poverty using the standard U.S. dollar per day definition, more than doubling the estimated number of poor people in China.

But then there is a further problem in using a single PPP indicator over a long period. The PPPs reflect the relative costs for a pattern of consumption prevailing at only one moment in time, but this pattern is actually constantly changing. So a snapshot of relative prices across countries at a point in time can give a misleading idea of time trends.

There is a less talked about but possibly even more significant conceptual problem with using PPP estimates. In general, countries that have high PPP, that is, countries where the actual purchasing power of the currency is deemed to be much higher than the nominal value, are typically low-income countries with low average wages. It is precisely because there is a significant section of the workforce that receives very low remuneration that goods and services are available more cheaply than in countries where the majority of workers receive higher wages.

Therefore, using PPP-modified gross domestic product (GDP) data may miss the point, by seeing as an advantage the very feature that reflects greater poverty of the majority of wage earners in an economy.

In other words, a country's exchange rate tends to be low or the disparity between the nominal value of the currency and its purchasing power tends to be greater because the wages of most workers are low. A low-currency economy is a low-wage economy, which is not something that should be celebrated. And that, in turn, gives a misleading picture of levels of income across countries, by making countries with low per capita incomes at actual (or nominal) exchange rates suddenly appear to be much less poor in terms of PPP.

Instead, if we actually look at the share of incomes across different country groupings in terms of actual exchange rates, it makes sense because of all the reasons mentioned above and also because of the fundamental point that global trade and investment flows actually take place in nominal exchange rates, not in some imaginary PPPs. So if relative economic power is to be assessed, it must be looked at in terms of the actual size of economies in terms of the rates that are used for cross-border transactions.

The shift in relative economic strengths, while still visible, is nowhere near as significant or major as is generally presented. The share of developed countries has certainly declined in the past two decades by nearly 15 percentage points but they still account for more than 70 per cent of global income. And while developing countries have more than doubled their share in the same period, they still have achieved less than 30 per cent share. This is certainly not as stark in terms of presenting an imminent handover of global power.

When individual countries are considered, the U.S. still accounts for nearly a quarter of global output, and the euro area is nearly one-fifth. China is still less than 10 per cent, and India is less than 3 per cent.

This is not to deny the clear direction of change but simply to point out that the process still has a very long way to go before it can become really significant. This is certainly worth pointing out to those in the North who are currently obsessed with the fear of the southern takeover. But it may be even more important to remember in the South, especially among people whose gung-ho optimism in this regard is not always tempered by reality. Especially in South Asia, our development project remains woefully incomplete but our income levels are also still really low.

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