Benchmarking: Adjusting for Exchange Rates

In conducting international benchmarking studies of a regulated firm’s prices, it is necessary to convert prices in different countries to a common currency. This can be done using nominal market exchange rates, or purchasing power parity (PPP) exchange rates.

There is no single, clear-cut rule as to which approach is preferred for telecommunications benchmarking.  For instance, each year the OECD presents price comparisons for telecommunication baskets of services for its country members both using nominal exchange rates as well as PPP rates.

The use of PPP rates for benchmarking telecommunication prices is gaining popularity but it is important to bear in mind the assumptions amd implications behind of the theory of PPP of exchange rates.

Basic concepts of PPP

The PPP theory was created to explain how the exchange rate is determined at the macroeconomic level.  The idea behind the PPP is the “law of one price” applicable to the pricing of goods and services.  Pursuant to this “law” a good or service marketed internationally without any trade or capital barriers, must have the same price in the domestic and international markets, i.e.

  Pi = Pi* E         (1)

Where Pi  is the price of the good or service in the domestic market, Pi* the price in the international market, and E is the exchange rate, say Mexican pesos / US dollars. The PPP generalizes the “law of one price” for which purpose a series of assumptions must be fulfilled. In the aggregate, the price level of a similar goods and services baskets in various countries must always be equal among them, when measured in the same currency.

      P = P* E      (2)

Where in this case P and P* refer to a price level for a series of goods and services contained in one same usage basket.  Another way of expressing (2) is that the exchange rate in a country is determined by the ratio of the prices in the country in connection with the prices in the rest of the world.  This is what is known as the absolute version of PPP.[1]

Under the PPP the real exchange rate is always constant.  The definition of real exchange rate, Q, is

      Q = P* E  / P     (3)

And if (2) is substituted for (3) we obtain that the Q = 1 under the PPP in its absolute version.

The PPP exchange rate prediction, as well as its fundamental assumption of the “law of one price”, is long-term, due to the fact that, in the short term, there may be factors that limit the applicability of the PPP.  Since in the short term, the market exchange rate may deviate from the PPP exchange rate, such deviation is deemed to be an undervaluation (whenever the exchange rate is higher than that of the PPP exchange rate) or overvaluation (when the market exchange rate is lower than that of the PPP).

Some of the limitations on the use of PPP exchange rates are: [2]

  • The basic assumption behind the PPP, that of the “law of one price,” is not complied with in circumstances very commonly observed in international business markets: presence of rate barriers, non-rate barriers (bans, quotas), capital controls, price controls, etc.
  • The presence of nontraded goods, makes the validity of PPP even more difficult.  In the strictest sense, PPP is valid only for traded goods.  But the existence of nontraded goods and their prices in connection to traded goods is not necessarily captured by the PPP.
  • The effect pointed out by Balassa-Samuelson invalidates the PPP prediction due to the differences in productivities of the traded and non-traded sectors internationally.  The Balassa-Samuelson effect argues that the price levels of various countries whenever they are expressed in the same currency are positively related to the level of real income per capita level.  The higher the per capita income, the higher price for nontraded goods, which form part of the economy’s general price index.

Estimating PPP Exchange Rates

For cases in which it is decided to use PPP exchange rates, the best recommendation is to use the rates estimated by recognized international institutions such as the World Bank, International Monetary Fund or OECD. However, some institutions as the OECD releases its annual PPP estimates with some time lag and only for its 30 country members. Often a benchmarking exercise could require one to examine countries in which there are no available estimates for PPP or if they are available they might need to be updated.  In contrast, nominal exchange rates are readily available from public websites on a daily or hourly basis and for practically any country in the world.

If no information is available on PPP exchange rates for particular countries or for a particular point in time, one could attempt to estimate the PPP exchange rate.

The procedure described below can be difficult in practice. In particular identifying an appropriate base year is not an easy task. The procedure for estimating PPP exchange rates is:

  • Choose a base year in which a balance of payments equilibrium might have occurred and assume that the market exchange rate is the same as the equilibrium or PPP exchange rate,
  • Extrapolate the equilibrium exchange rate of the base year using the domestic inflation of each country and a measure of foreign inflation. To estimate domestic inflation, use either growth in the consumer price index or growth in a wholesale price index. For foreign inflation either the United States rate of inflation, or a weighted average of inflation in the country’s main trading partners can be used.

This calculation is shown algebraically below.

If s0 is the exchange rate in the base year, then the parity exchange rate for year t will be equal to:

Where  is domestic inflation between year t and base year, and  is foreign inflation over the same period.

Endnotes:

[1] The PPP relative version maintains that the percentile variation in the nominal exchange rate is equal to the percentile variation in the ratio of the aggregate domestic and foreign price indices.

[2] Siregar, R., “The Concepts of Equilibrium Exchange Rate: A Survey of Literature.” Working Paper, School of Economics, University of Adelaide, Australia. June 2006.

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