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Purchasing power parity vs market exchange rate

Purchasing power parity vs market exchange rate

IN the changing global financial architecture, the purchasing power parity of a national currency with the hegemonic yet fluctuating dollar is being used more frequently to measure its GDP and its peoples’ standard of living, particularly in case of major emerging economies.

Experts say “the purchasing power parity (PPP) exchange rates are relatively stable over time. In contrast, the market rates are volatile”. But the PPP does not cover all countries.

The use of the PPP is gaining ground due to the volatility of market-driven exchange rates, which may or may not accurately reflect the size of a growing economy at a particular point of time and the potential it offers for foreign investment and trade.

The PPP throws up a different picture. Expressed in terms of a strong greenback, the GDP of a country with a weakening currency — as is currently the case with the emerging markets — contracts. But when expressed in terms of the PPP, it expands. Among others, this is true for Pakistan and China.

There is a huge difference in the two estimates: the GDP goes up in case it is measured by the PPP when compared to the calculation made at the weak market exchange rates.

Broadly speaking, the PPP is the exchange rate equal to the ratio of two countries’ price level for a fixed basket of goods and services. When the domestic price level is increasing, that country’s exchange rate must be depreciated in order to return to the PPP.

Critics say the drawback in this mode is that the basket of commodities (or the range of commodities) covered varies sharply from one national market to another.

On the other hand, the effective exchange rate is an index that shows the strength of a currency relative to a relevant basket of other currencies.

The underlying problem of measuring the GDP at the prevailing exchange rate is that the currency values fluctuate on a daily basis, depending on demand and supply, financial flows and speculative activity on perceived market trends. The value of a currency so determined may or may not reflect the fundamentals of the economy.

Quite a sizable amount of dollars are accumulated by many central banks just to beat back speculative attacks on their currencies and keep some semblance of exchange-rate stability. Pakistan has piled up foreign exchange reserves of nearly $20bn — that too primarily from foreign debts — just to keep the rupee stable as long as its manageable.

The rupee was recently allowed to depreciate in response to the 2pc devaluation of the Chinese yuan. The problem now facing policymakers is that both exports and imports are falling despite the depreciating value of the rupee. Many countries, including Pakistan, are therefore, by choice or compulsion, trying to focus on domestic and regional markets.

The dollar still remains, to a very large extent, the reserve currency of choice for central banks, a store of value, and the medium of exchange for goods and services globally.

Many people had pinned their hopes that the euro would compete vigorously with the dollar for global hegemony, or that the yen or the yuan would make some dent in the dollar-anchored global financial transactions. But nothing like that is in sight.

The crisis in the eurozone has become more difficult to resolve in the absence of national currencies. For example, the Greece crisis could have been less difficult to solve if the country had its own national unit and the option to devalue it. So, many critics see the future of euro at stake.

In the case of the greenback, the situation is different. The dollar is a national currency with a virtually unchallenged global reach. Ideas like making the IMF’s special drawing rights (SDRs) an international currency have not caught the imagination of the policymakers who could make the difference. Perhaps such a decision may follow when the shareholding in the IMF becomes wider and much more representative of the changing economic and financial order.

Meanwhile, the two different approaches — the PPP and the effective exchange rate — throw up different perspectives. This would perhaps lead to a better understanding of the emerging realities and informed decision-making about global investment and trade.

Published in Dawn, Business & Finance weekly, October 19th , 2015

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