Sridhar Vembu’s Blog

If you follow world economic figures, you will notice the huge gap between per-capital GDP figures between countries.

A country like US boasts a per-capita GDP of around $35,000, while for India it is in the abysmal $400 per year. A middle income country like Malaysa has around $7,000 while a recently industrialized country like Taiwan is in the range of $20,000.

These figures, while true, really hide a lot more than they reveal. The biggest misleading aspect is the exchange rate. A country like India, while poor in absolute terms, is richer than the $400 per-capita figure would indicate. Economists tend to use the purchasing power parity to try to derive a figure based on equivalent purchasing power. But such a PPP figure only indicates purchasing power in domestic markets. In international markets for commodities, the figure based on current exchange rates is a truer measure of a country’s wealth.

As a country gets wealthier, it gets a double boost. Take India’s case. Say the economy grows at around 7-8% per year as measured in rupee terms, but currency appreciates at 5% per year (as measured in rich country currency terms, in this case the US dollar). Note that the 7-8% growth rate is measured in “real” or inflation-adjusted rupee terms, and rupee itself is losing value at a rate of around 5% due to inflation, the “nominal” rupee GDP is growing at around 13% or so. Add in the effect of rupee appreciation, you get a “Indian GDP as measured in current dollars” is growing at 18% or so. At that rate, the dollar-GDP (measure of Indian’s worldwide purchasing power) doubles every 4 years. In 20 years, you it grows 32 times, to reach around $12,000 per capita - voila, India is solidly in the upper middle income range.

This is the magic by which a country like Taiwan or Korea joined the rich world in 25-30 years. 18% a year compounds a lot faster than 8% per year. If we naively project local-currency GDP growth rates (if it is 8%, GDP doubles every 9 years), it would take 45 years for GDP to reach the $12,000 range, starting at $400 today.

Of course, currency adjustments don’t happen in a smooth, orderly 5% a year step. Currencies tend to adjust suddenly - in Japan’s case, it doubled in just 4 years between 1984 and 1987, pushing Japan from a upper middle income country to one of the richest countries in the world, seeminly in the blink of an eye.

This distinction between GDP-in-local-currency terms and GDP-in-current-dollars matters a lot to international businesses, because a country’s external purchasing power (this is what boosts their imports) grows a lot faster than the GDP growth figures would indicate. It is often captured in the fact that as a country grows, its external trade grows a lot faster than GDP.

In fact, many countries in Eastern Europe, are catching up to rich country GDP levels quite quickly, without their GDP growth rates ever achieving Asian-tiger levels. The reason is the magic of currency adjustments.