By Dr. Nayyer Ali

June 10, 2005

Purchasing Power

Pakistan has had a very good economic year. GDP growth will likely finish June 30 at about 8.4%, the best performance in 20 years. Good weather certainly helped, but Pakistan has had good weather in the last 20 years on several other occasions. Good policies allowed Pakistanis the chance to take advantage of favorable economic winds. But even after this last twelve months of growth, Pakistan is still a very poor country. In fact according to government statistics, per capita income is only 683 dollars. This leads to an obvious question, how does anyone live on 683 dollars per year?
The answer is they don’t. Pakistanis don’t live on an average of 683 dollars per year, they live on an average of 41,000 rupees per year. Pakistanis live in a rupee economy, not a dollar economy. Logically, that shouldn’t make a difference. All we need to do is convert the rupee figures into dollar using the market exchange rate. But that would be wrong.
Why? Because price levels in the US economy in US dollars are much higher than price levels in Pakistan’s rupee economy. As any of the readers of this column who have visited Pakistan or any other foreign country know, goods and services don’t cost exactly the same abroad as they do in America. In fact, in poor countries with much lower average wages, there can be huge differences in what certain items cost.
For purposes of foreign investors and assessing world trade, the market exchange rate is the most reliable figure. It provides useful information for those purposes, and can be calculated with reliable precision, as long as the exchange rate is truly market-based, and the foreign government can reasonably measure its own economy.
But for those working in the field of development, the market exchange rates were unsatisfactory. They did not give a very accurate assessment of living standards within a country, nor its relative standard compared with more developed societies. For example, we all know that although Pakistan is a poor country, per capita income is not merely 2% of America’s.

Leading thinkers in the development field however did not know a way to reliably fix this problem. Within any Third World economy there were basically two classes of goods and services, those that could be traded with the outside world, and those that could not. Tradable goods, such as a 767 aircraft, or computers, or cars, or cell phones, or wheat, would command the same price throughout the world, and locally. But non-tradable goods and services, cost much less. This is because non-tradable goods had a large component of local labor cost in them, and those labor costs were much lower than in America. For example, the cost of property would reflect the lower labor cost of construction workers in Pakistan than in the US, or university tuition would reflect the lower cost of professor salaries, or restaurant meals would reflect the lower labor costs of cooks. In general, the lower labor costs reduced substantially the costs of local products and services. The end result is that one can buy more with a rupee than the dollar equivalent can purchase in the US.
The World Bank tackled this problem in a systematic way with the “International Comparison Program”, which essentially consisted of the World Bank getting price data on a large range of goods and services in every country on the Earth. By then crunching a formula, the Bank could reduce it all to what they called a “Purchasing Power Parity Conversion Factor”. This factor is meant to quantify the price level in any economy relative to the US. How to handle the significance of the price of pork or alcohol in Muslim countries, or beef in India, or wheat in a country that eats rice, and other similar questions created a host of headaches in this process.
It comes as no surprise to find that the poorer the country, the lower the relative price level as compared to the US. To find out what the real standard of living in a country is compared to the US, or to other countries, the process simply requires converting the market rate GDP per capita to a “Purchasing Power Parity” GDP per capita by dividing by the conversion factor. In both Pakistan and India that factor is .2, meaning that average prices in South Asia are 20% of the US. Given Pakistan’s current market GDP per capita of 680, its PPP GDP per capita is 3400 dollars. Which means that Pakistanis on average are at about 8% of the US level. On the other hand, with 6% growth in per capita income for 25 years, Pakistan would reach 14,000 dollars, which would be the low end of a developed society, and similar to the US in 1960.
As countries develop, their price levels rise and gradually converge with developed countries. For the World Bank, this means that their PPP conversion factor needs periodic updating. The last update was done in 2000, and a current round is in data collection, with an update due in 2006. Comments can reach me at Nali@socal.rr.com.

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