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Home , Purchasing power parity

Parity Measures of Competitiveness

LEONARDO BARTOLINI

short run, or of exchange rates between indus- vices should the same amount in all coun- OVERNMENTS are trial and developing countries, either in the tries when expressed in a common . long or the short run. Examining changes in Clearly, if the law of one holds for every perennially concerned competitiveness alone is also not very helpful good, then absolute PPP should also hold. over whether their in explaining developments in external . Absolute PPP, however, requires the parity G It is necessary to incorporate the analysis of relationship to hold only on average for all countries' products are competitiveness in a broader framework —not strictly for each good. internationally competitive. But —taking into account structural and cyclical Absolute PPP provides a specific equilib- economic developments, government policies, rium concept for the nominal , how should competitiveness be and financial conditions—that may namely, the PPP exchange rate. This is assessed? Indicators based on explain long-lasting changes in equilibrium defined as the rate that equalizes the of the concept of purchasing power real exchange rates. a common basket of goods in two different countries. Deviations between the market parity are useful benchmarks What is PPP? exchange rate and the PPP exchange rate are but cannot account for Three versions of PPP have traditionally viewed as short-lived, as they should be elimi- been used in the literature: the law of one nated by arbitragers purchasing goods in one structural developments that price, which relates exchange rates to prices of country and selling them in another. cause long-term shifts in individual homogeneous goods in different Despite their intuitive appeal, the empirical countries; absolute PPP, which relates ex- usefulness of the and of abso- equilibrium real exchange rates. change rates to overall price levels; and rela- lute PPP is limited. Transportation and infor- tive PPP, which relates exchange rate changes mation and institutional impediments to to rates. trade, such as tariffs and quotas, may limit An important determinant of a country's The law of one price states that when there consumers' and firms' responses to cross- external payments position is its international are no transaction costs or trade barriers (such country price differences, thus preventing competitiveness. The most common approach as tariffs or quotas), the prices of identical absolute price levels from being equalized to the analysis of competitiveness involves a goods sold in different countries should internationally. Relative PPP is a yet weaker comparison of movements in exchange rates be the same when expressed in a common condition than absolute PPP and predicts only and prices, based on the concept of purchas- currency. Empirically, the law of one price that changes in nominal exchange rates ing power parity (PPP). This approach pre- appears to hold well for homogeneous pri- should equal the difference between domestic dicts that real exchange rates should tend to mary traded on major ex- and foreign inflation on equivalent baskets of return to a constant long-run equilibrium in changes, when adjustments are made for goods. If PPP is judged to hold in some partic- response to short-run shocks and, therefore, contract differences and delivery lags. Not sur- ular year, one can obtain, from a time series of that nominal exchange rate movements prisingly, however, the prices of differentiated the inflation differential, the implied PPP nom- should tend to offset relative price movements. products, such as manufactured goods and inal exchange rate, which can then be com- Empirical evidence suggests that PPP- services, tend to deviate to a greater degree pared with the market exchange rate. based indicators may be useful to explain from the law of one price. long-run movements in exchange rates among Absolute PPP extends the law of one price Deviations from PPP industrial countries, but less so to explain to the general . Absolute PPP pre- Most economic theories suggest that PPP movements of these exchange rates in the dicts that the same basket of goods and ser- should hold in the long run for traded goods,

Leonardo Bartolini, an Italian national, is an in the Economic Modeling and External Adjustment Division of the IMF's Research Department.

46 Finance & Development / September 1995

©International Monetary Fund. Not for Redistribution assuming that measurement problems (the export unit ), for the involved in constructing comparable Chart 1 period from 1975 to 1994. The chart Comparing real exchange rate indicators price deflators can be resolved (see highlights the sharp appreciation of : Real effective exchange rates below). Empirical evidence on the valid- (1985=100) the CPI-based real exchange rate of ity of PPP is mixed, however (see the the yen, and the contrasting broad article by R. MacDonald for a survey of constancy of the export price-based this evidence). On the one hand, there is real exchange rate. The divergence a growing amount of evidence suggest- between the two indicators provides ing that PPP represents a reasonable clear evidence of the impact of Japan's characterization of long-run movements fast growth of productivity in the in industrial countries' exchange rates export sector. and traded goods' prices. On the other In summary, while it is useful to hand, there is ample evidence that PPP think of "competitiveness" as the rela- does not explain well the behavior of tive position of a country's exchange industrial countries' exchange rates in rate with respect to its long-run equi- the short run. Furthermore, when librium value, it is not always easy to exchange rates and price movements are distinguish empirically between a compared between industrial and devel- change in the real exchange rate that oping countries—either the long run or Sources: IMF, International Financial Statistics, various issues, and reflects a change in competitiveness staff estimates. the short run—PPP is clearly rejected, 1 Does not include data on from 1975 to 1980. or a structural change that leads to a as large differences between inflation dif- persistent change in the equilibrium ferentials and bilateral exchange rate real exchange rate. Indeed, it is mis- changes persist in most cases over long leading to regard every real deprecia- horizons. growth can cause persistent changes in real tion as an improvement in a country's Research on exchange rates has considered exchange rates, and hence long-lasting devia- competitiveness, as this may reflect a simulta- four main reasons for deviations of real tions from PPP. neous decline in both the current real exchange rates from their PPP value: "hystere- Finally, but perhaps most important, differ- exchange rate and its long-run equilibrium sis" effects due to adjustment costs; nominal ential rates of technical change in the traded value. If, for example, world demand for a par- price rigidities; imperfectly substitutable and nontraded sectors have long been recog- ticular primary declines, the price traded goods; and structural changes in tech- nized as a cause of sustained movements in of this commodity will fall. Both the long-term nology and demand, particularly between equilibrium real exchange rates and, there- equilibrium and the current value of the real traded and nontraded . The fore, as a reason for the persistent failure of exchange rate of a country specializing in the first two factors explain why PPP can fail over PPP. This is because, while market competi- production of that commodity will then depre- short horizons, while the last two can cause tion may keep prices of tradables broadly ciate. Clearly, however, this country will not be persistent failure of PPP. aligned internationally, prices of nontradables able to sell its products with any greater ease "Hysteresis" models of trade attribute tem- need not move together in different countries. at the lower exchange rate. porary deviations from PPP to the presence of Thus, if the real exchange rate between two This difficulty of assessing the dynamics of adjustment costs in trade. These costs, which countries is computed using price deflators equilibrium real exchange rates, combined include the marketing of new products abroad, that include both tradable and nontradable with statistical problems such as constructing expanding or reducing production or distribu- goods (such as the consumer (CPI) qualitatively homogeneous baskets of goods tion lines, and altering brand recognition, or the GDP deflator), then countries with and services, is central to any analysis of com- imply that trade flows need not respond to faster growth of productivity in the traded petitiveness. Furthermore, temporary devia- small changes in real exchange rates, as only sector (notably manufacturing) than in the tions of current exchange rates from their large departures from PPP would trigger nontraded sector (notably services), will medium- or long-run equilibria do not neces- exporters' response. exhibit a tendency toward real appreciation. sarily call for policy intervention, for they do Sticky price models of exchange rates recog- This phenomenon (the so-called Balassa- not necessarily reflect a . As nize the different speed of adjustment between Samuelson effect) is often advanced as an noted above, real exchange rate fluctuations financial markets and goods markets: the for- important factor underlying the long-term may well reflect optimal market re-sponses to mer respond swiftly to exogenous shocks, appreciation of industrial countries' real a variety of exogenous shocks, which policy- while the latter adjust more slowly. As a exchange rates relative to developing coun- makers need not be called upon to correct. result, unanticipated changes in monetary tries, but also as explaining movements in conditions may cause nominal exchange rates equilibrium real exchange rates among indus- Assessing competitiveness to deviate temporarily from their long-run trial countries. Japan, for instance, is often Owing to the difficulty involved in measur- PPP equilibrium. cited as the classic case of a country where ing changes in international competitiveness, A third factor generating departures from faster growth of productivity in the traded vs. and policymakers rely on a variety PPP is the imperfect substitutability among nontraded goods sectors relative to its trading of indicators to provide a broad assess- different countries' traded goods, which allows partners has caused a real appreciation of its ment—however imprecise—of developments exporters to adjust prices to local market con- currency. Chart 1 illustrates this fact by dis- in real exchange rates that may affect a coun- ditions, failing to offset changes in exchange playing two different measures of the yen's try's ability to trade in world markets. These rates by corresponding price changes. In this real effective exchange rate, one defined in indicators differ primarily in their use of dif- situation, cross-country differences in growth terms of a composite price index (the CPI) and ferent price indices to deflate nominal rates and in the response of trade to income one defined in terms of a tradable-only index exchange rates. For instance, a real exchange

Finance & Dnvtopmcnt /September 1995 47

©International Monetary Fund. Not for Redistribution More comprehensive measures of price Chart 2 competitiveness can be constructed on the Trade flows and competitiveness basis of either aggregate price deflators or of unit labor costs. A GDP-based real exchange rate, for instance, would reflect the ratio of the and Japan: Selected indicators relative prices of nontraded to traded goods at home and abroad, so that a rise in this index would indicate either a loss of competitiveness in the traded goods market, or a greater incen- tive to allocate resources to the nontraded goods sector at home. In addition to GDP deflators, other broad indicators of competi- tiveness involve wholesale price indices, value- added deflators, and CPIs. Wholesale and value-added measures tend to be very impre- cise, lack cross-country comparability, and are typically available only for the manufacturing sector, often with a substantial delay. CPIs are available on a more timely basis and with greater frequency, but reflect taxes and other institutional distortions, as well as prices of imported goods, thus making the associated measures of competitiveness less indicative of the prices faced by producers. A real exchange rate index defined in terms of relative unit labor costs (ULCs) in the traded goods sector typically compares the profitabil- ity of nonlabor factors in producing manufac- tured goods at home and abroad. Implicit in this measure is the notion that exchange rates operate to equilibrate the rate of return to nonlabor across coun- tries. ULC-based indicators have the advan- tage of being defined rather similarly across countries, although an unduly restrictive focus on the manufacturing sector is typically re- quired to assure this homogeneity. Further- more, because they are defined in terms of unit (or average) labor costs, they provide only a rough approximation of the relative incentives for labor allocation at home and abroad, which should be measured by marginal labor costs. Because the relation- ship between marginal and average labor costs varies with capital/output ratios, Sources: IMF, International Financial Statistics, various issues, and staff estimates. changes in unit labor costs may reflect only changes in capital/output ratios that are unre- lated to competitiveness. Nonlabor costs also rate index based on the prices of tradable ciently low—at the current exchange rate—to include costs other than the remuneration to goods is defined as the ratio of a weighted be exported. Furthermore, if traded goods are capital, such as the rental of land and the cost average of the home country's prices of close substitutes, then an export-based real of intermediate goods and primary commodi- exported goods to a weighted average of its exchange rate is likely to show little variation, ties. In principle, labor cost indices could be partner countries' prices of exported goods, all as exporters will adjust prices quickly in corrected for the share of value added domes- expressed in the same currency. A rise in this response to exchange rate changes—even tically, but this correction is difficult to carry indicator is viewed as signaling an increase in though operating profits may vary as a result. out in practice. ULC-based indicators also a country's export prices above their "world" Chart 1 shows that this has indeed been the tend to become available with delay and are level, and hence a loss of competitiveness for case in Japan. If exporters "price to market" often subject to large measurement errors. the home country in its export markets. by altering margins in the short run, an The main practical shortcoming of an export-based index of competitiveness would Recent experience export-based index of competitiveness is that provide little information on the long-term How useful are the competitiveness indica- it does not include all potentially exportable profitability of domestic producers relative to tors discussed above as predictors of goods, but only those that are priced suffi- their foreign counterparts. exchange rate pressure and changes in trade

48 Finance & Development / September 1995

©International Monetary Fund. Not for Redistribution volumes? A recent study by P. Turner and J. behavior of three of the real exchange rate move real exchange rates toward their long- Van't dack (see suggestions for further read- indices discussed above and the trade balance term equilibrium, but a more comprehensive ing) cautiously suggests that standard indica- in the United States and Japan from 1980 to framework is needed to explain changes in the tors of competitiveness provide a useful 1994 (Chart 2). Because of the strong equilibrium rates themselves. HI picture of trends in exchange rates, prices, and of nominal exchange rates relative to that of productivity in the main industrial countries. prices, the different indicators of competitive- L. Lipschitz and D. McDonald studied the evo- ness tend to be highly correlated in the short A longer version of this article was drafted as a lution of 's competitiveness during run. The main exception is the slow response chapter of Exchange Rates and Economic the 1980s vis-a-vis its European partners and of Japan's export unit value index to the Fundamentals, IMF Occasional Paper No. 115, showed that the ability of ULC-based real appreciation of the yen in the second half of co-authored with P Clark, T. Bayoumi, and S. Symansky. exchange rates to predict changes in the 1980s, which partly reflects the effort of European trade shares could be enhanced by Japanese firms to maintain market shares adjusting this indicator to account for move- despite unfavorable exchange rate fluctua- ments of value-added deflators. This study tions. Chart 2 also shows that whereas for the Suggestions for further reading: also suggested that the inability of standard United States, real exchange rate apprecia- L. Bartolini, "Devaluation and Competitive- ness in a Small Open Economy: Ireland GDP-based and CPI-based indicators of com- tions have been broadly associated with a 1987-1993," Economic and Social Review, petitiveness to predict the pattern of market declining trade balance, the opposite has been Vol. 26 (April 1995); F. Caramazza, "French- shares during this period could be explained true for Japan. German Rate Differentials and Time- by the slower rate of productivity growth in Varying Realignment Risk," IMF Staff Papers, Germany's traded goods sector vis-a-vis its Conclusion Vol. 40 (Washington, September 1993); partners. I. Marsh and S. Tokarick compared Changes in competitiveness are important, P. Clark and others, Exchange Rates and the ability of several competitiveness indica- yet only partial, determinants of external posi- Economic Fundamentals, IMF Occasional tors to predict trade flows. They found evi- tions. Policymakers are likely to be interested Paper No. 115 (Washington, December 1994); dence of a long-run response of trade to in developments in a country's competitive- L. Lipschitz and D. McDonald, "Real Exchange competitiveness, but little evidence of such ness—particularly when these developments Rates and Competitiveness: A Clarification of linkage in the short run. None of the indica- are the results of specific policies—as these Concepts and Some Measurements for "IMF Working Paper No. 91/25, IMF tors examined seemed to uniformly outper- crucially affect trade performance. A coun- (Washington, March 1991); I. Marsh and try's competitiveness, however, reflects a form the others in terms of predictive power. S. Tokarick, "Competitiveness Indicators: A Some recent studies have also tried, variety of factors that affect relative profit Theoretical and Empirical Assessment," IMF with some success, to link market-based opportunities in the tradables and non- Working Paper No. 94/29 (Washington, March expectations of exchange rate changes to tradables sectors, including structural and 1994); R. MacDonald, "Long-Run Exchange macroeconomic "fundamentals," including cyclical developments in productivity and Rate Modeling: A Survey of the Recent competitiveness. F. Caramazza, for example, demand, and financial market conditions. Evidence", IMF Working Paper No. 95/14 found that investors' anticipations of a Competitiveness indicators alone are unlikely (Washington, January 1995); K. Ohno, realignment of the French/German exchange to adequately account for these macroeco- "Estimating Yen/Dollar and Mark/Dollar rate mechanism (ERM) parity from 1987 to nomic "fundamentals," which are likely to Purchasing Power Parities," IMF Staff Papers, Vol. 37 (Washington, September 1990); A. 1991 could be explained in large part by vari- affect the intertemporal dynamics of trade Rose andL.E.O. Svensson, "European flows no less than exchange rates do. In fact, ables such as inflation rates and export com- Exchange Rate Credibility Before the Fall" petitiveness. L. Bartolini found similar results these "fundamentals" are likely to lead to European Economic Review, Vol. 38, for Ireland, while A. Rose and L.E.O. Svensson long-lasting changes in equilibrium real pp. 1185-1216; P. Turner and]. Van't dack, reached more mixed conclusions. exchange rates, and hence may underlie the "Measuring International Price and Cost The difficulty involved in establishing a observed long-term trends in the competitive- Competitiveness," Bank for International clear link between real exchange rates and ness indicators themselves. Changes in com- Settlements, Basle (November 1993). trade can be illustrated by examining the petitiveness generate economic forces that

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