Friday, August 26, 2005

The Value of Money

Does China have the Second-Largest GDP in the World?

According to statistics reported by the China Daily, China's gross domestic product for 2004 was in the neighborhood of 13.65 trillion yuan (or 1.65 trillion USD, with an exchange rate of 8.28 yuan per dollar). Using only the exchange rate to convert yuan to dollars, however, does not reveal the entire story. Indeed, the CIA ranks China second in the world, behind only the United States, in terms of GDP. The figure they use is 7.26 trillion USD for China's GDP.

In terms of only the exchange rate (8.28 yuan per dollar) the World Bank ranks China's economy 7th in the world at 1.65 trillion USD. The IMF ranks China sixth in terms of GDP.

But when purchasing power parity, rather than the exchange rate, is used to “compare” China's GDP to those of other countries, the situation changes. This is why the CIA ranks China second in the world. This is also true of data from the IMF (see list here).

Purchasing power (also known as PPP, or purchasing power parity) is the principle that money used domestically can be exchanged for a certain amount of goods and services. Put simply, money has a certain value. To compare the value of money, one cannot rely simply on the exchange rate. The value of 1 yuan in China, that is the amount of goods and services it will buy, can be compared to the value of 1 USD in the United States. To make this comparison, economists choose a “basket” of goods and services and then compare the price in different countries, usually using the U.S. basket as a benchmark. In theory, a vast discrepancy between exchange rate and purchasing power will lead to arbitrage, since one can simply keep buying goods at the lower price until the exchange rate equalizes. China pegging the yuan to the dollar, however, keeps the rate stable regardless of inflows of foreign dollars. (There is a good article in the April 4, 2005 Business Week on “Hot Money,” but it is available to subscribers only).

The Economist has compiled a Big Mac Index which uses the price of a Big Mac to relate the purchasing power of currencies to each other (the benchmark is a $3 U.S. hamburger, so if the same burger is cheaper in China, purchasing power is greater there). For China, they cite a figure of 3.43 as the PPP of the dollar. This would imply, using the Economist Intelligence Unit's figure of 1.68 trillion USD for China's GDP, a "Big Mac" adjusted GDP of 5.76 billion USD. That is, in terms of purchasing power, China's has a GDP of 5.76 trillion USD (FIY the Economist Intelligence Unit’s own figure for GDP in terms of purchasing power is 7.55 trillion USD, using 4.5 for its purchasing power ratio or a yuan-to-dollar rate of 1.84).

The more common figure for understanding the purchasing power of China's economy is 1.8 (from the World Bank's World Development Indicators report, listed here). Using quick and easy math, divide the exchange rate (8.28 yuan per dollar) by the purchasing power conversion factor (1.8 yuan per dollar) and you get a unit-less ratio of 4.6. What it means is that 1 USD buys 4.6 more value in China than in the United States. Converted in this way, China's GDP ranks second in the world.

I am not an economist. The above was gleaned from the web over the past week. I can only provide my experiences as a confirmation of the relevance of purchasing power to converting statistical figures that come out of China these days.

Two anecdotes
Before I went to China for the first time with University of California's Education Abroad Program in 2000, I attended an orientation hosted in Berkeley. One of the speakers, a past participant, noted that one should not argue vigorously with petty traders over a few yuan. Later, I expressed my unease with such a blanket statement. An economics undergraduate, who was giving me a ride, vehemently defended the speaker. The ride home was quite unpleasant as I stuck by my conviction that despite the fact that a couple of yuan was only a quarter or two, I did not want to give away my quarters. I also felt that such unequivocal rendering of exchange was dismissive of the context one might encounter in China.

Living in Beijing for several years since the yuan polemic, I discovered the real power of money. In Beijing, in Zhongguancun, a nice two-bedroom apartment cost me 2,400 yuan a month (about 300 USD). This was a nice area, convenient, clean, and safe. But my friends in China chided me that it was too expensive, since the apartment lacked a refrigerator. I scrimped money by eating fast food (a bowl of rice topped with one item of cuisine) for 5 yuan a meal. But herein is the evidence for purchasing parity calculations.

In China, or Beijing nonetheless, the cost of daily living is much cheaper than in equivalent cities in the U.S. Therefore, a figure such as the ratio 4.6 worked out above for multiplying China’s GDP (or other figures such as the Big Mac Index) is reasonable. An 8 yuan meal in Beijing converts via the exchange rate to a 1 USD meal. But using the purchasing power multiplier, it is really a 4.6 USD meal. That is much closer to actual experience, since I can buy rice topped with food items in San Francisco for about 4 USD. Rent, too, should be viewed this way. My two-bedroom apartment in Beijing only cost 300 USD a month. But in real purchasing power terms, it cost 300*4.6 = 1,380 USD a month. That seems to fit reality much closer, since 300 USD rents you only a storage unit in San Francisco, while 1,380 USD would get you a nice two-bedroom apartment.

Purchasing power arguments notwithstanding, the official exchange rate of 8.28 (or, now, 8.11) yuan per dollar tells us little about what a dollar or a yuan actually purchases in China. Certainly, the point can be made that Starbucks coffee in Beijing is more expensive than it is here (it costs 16 yuan or 2 USD for a cup of Starbucks coffee in Beijing). But the point is that that coffee costs more in value in China than it does in the U.S. To understand the equivalence in value, rather than in monetary, terms, one must use purchasing power. Hence that cup of Starbucks coffee really costs you 9.2 USD in terms of equivalent value forsaken to imbibe the brewed beverage. There are real reasons to vehemently bargain over “a few yuan.”

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