Why We Adjust Costs for PPP

The Transit Costs Project adjusts all construction costs for purchasing power parities. This means that, for example, a Chinese subway is converted into dollars not at the exchange rate of $1 = 6.7¥, but at the PPP rate of $1 = 4.2¥; this means that present-day Chinese subways look 1.5 times more expensive in our analysis than in analyses that use exchange rate values, and projects from 10 years ago look twice as expensive. I believe our choice is correct, and would like to explain why, since it has gotten some criticism from serious people, who’s prefer exchange rates.

Local costs

I started this comparing mature developed countries. The US and Europe have largely separate markets for construction, and so American work is almost entirely done in dollars and European work in euros (or pounds, or kronor, etc.). Japan is likewise very local and so is China. In that case, local costs matter far more than international ones.

But what’s interesting is that even in countries that use imported technology and international consultants and contractors and have low wages, costs are almost entirely local. I wrote about this last year, referencing an article out of India about the small cost impact of indigenization and an interview I made with a Philippine planner who told me 90% of the value of civil works is local. Rolling stock is internationally traded, but we exclude it from our cost estimates whenever possible.

The impact of currency changes

Using PPPs, if a country undergoes a bout of inflation, this should be reflected in changes in construction costs. This is intentional. The example given to me in the critique linked in the lede is that if Bangladeshi food prices rise, then this makes the PPP exchange rate look less favorable (a taka in Bangladesh can then buy less relative to a dollar in the US). But that’s fine – if Bangladeshi food prices rise then this forces Dhaka to pay higher wages to MRT construction workers, so overall it’s just domestic inflation. It’s no different from how, today, we’re seeing nominal construction cost growth in the United States and Europe because of high inflation.

At least the inflation today is moderate by any developing-country standard. Core inflation in the United States is 6%; in Germany it’s 3%. This may introduce third-order errors into the database as we deflate costs to the midpoint of construction. In contrast, 50-60% annual inflation is sustained over years in some middle-income countries like Iran, and then the choice of year for prices has significant impact, to the point that Iranian costs have a significant error bar. But that’s regardless of whether one adjusts for PPP or not, since usually inflation leads to deteriorating terms of trade.

In contrast, if prices are compared in exchange rate terms, then international fluctuations create fictitious changes in construction costs. When China permitted the renminbi to appreciate in the mid-2000s, this would have looked like an increase in costs of about 20% – but the costs of local inputs did not change, so in reality there was no increase in costs. The euro:dollar rate peaked around 1€ = $1.58 in 2008, before tumbling to 1€ = $1.28 in the financial crisis – but nothing material happened that would reduce European construction costs by 19% relative to American ones; right now it’s trading at 1€ = $1.05, but this again does not mean that construction in Europe is suddenly a third cheaper compared with in the US relative to 15 years ago.

Unusual currency values

Some patterns are systemic – richer countries have stronger currencies relative to PPP value than poor countries. But others are not, and it’s important to control for them. A currency can be weak due to the risk of war or disaster; the Taiwanese dollar is unusually weak for how rich Taiwan is, and this should not mean that Taiwanese construction costs are half what they really are. Or it can be strong or weak based on long-term investment proposition: investors will bid up the value of a currency in a country they expect to profit in in the long term, perhaps due to population growth coming from high birthrates or immigration, and this does not mean that today, it builds infrastructure more expensively.

In any of those cases, the unusual value of the currency really reflects capital availability. Capital for investment in Australia is plentiful, but this by itself does not raise its construction costs; capital for investment in Taiwan is scarce, but this certainly does not make it a cheap place to build infrastructure.

Foreign-denominated construction

In some peripheral countries with unstable currencies, costs are quoted in foreign currency – dollars or euros. Some Turkish contracts are so quoted, and this is also common in Latin America and sometimes Southeast Asia. But ultimately, the vast majority of the contract’s value is paid out in the local currency, not just labor but also locally-made materials like concrete. This creates a weird-looking statistical artifact in which we convert dollars or euros to local currency in exchange rate terms and then back in PPP terms.

This, we do because the quotation of the contract (in dollars or euros) is not the real value. Rather, it comes out of one of two artifacts. The first is data reporting: we rely on international trade media, and those often quote prices in exchange rate dollars or euros, even if the contract is in local currency (and in all cases where we’ve seen both, they match in exchange rate value).

The second is that an international consultancy may demand actual payment in foreign currency as a hedge against currency depreciation; in that case its rate of profit should be dollar- or euro-denominated. However, this again is a small minority of overall contract value. Moreover, if a country’s institutions can’t produce enough capital stability to do business in their own currency, it’s a problem that should be reflected in global indices; ultimately, if costs are higher in PPP terms as a result, this means that the country really does have greater problem affording infrastructure.

A posteriori justification

The above reasoning is all a priori. When I started comparing costs in the early 2010s, I was comparing developed countries and the euro:dollar rate was in flux in the early financial crisis, so I just went with one long-term PPP rate.

However, a posteriori, there is another positive feature of PPP adjustment: it levels the differences in construction costs by income. There is positive correlation between metro cost per km and the GDP per capita of the country the metro is built in, about 0.22, but it comes entirely out of the fact that poorer countries (especially India) build more elevated and fewer subway lines; correcting for this factor, the correlation vanishes. This is as it should be: PPP is a way of averaging out costs in different countries, first because it levels short-term fluctuations such as between different developed countries, and second because exchange rate value is dominated by internationally tradable goods, which are relatively more expensive in poor countries than non-tradable goods like food and housing.

What this says is that infrastructure should be viewed as an average-tradable good, at least a posteriori: its variation in costs across the world is such that there is no correlation with GDP per capita, whereas food prices display positive correlation even after PPP adjustment, and tradables like smartphones display negative correlation (because they cost largely the same in exchange rate terms).


  1. Tonami Playman

    How does local tax and fare collection towards loan repayments for transit projects play into this? Is it more or less consistent when using currency exchange or PPP rate or is loan repayment not a factor at all?

  2. Phake Nick

    Main trade partner, and competitor, of Taiwan is China. I doubt NTD can be made more valuable compared to the CNY’s current rate, without losing much competitiveness.

      • Phake Nick

        More accurately would be electronics and electronic components. They don’t have much end product of their own in the international market where highest premium can be charged. Even in tern of things like chips, they mainly produce design made by companies from all over the world. These are aspects that China is still worse off and also have other concerns that might prevent Western companies from moving their order to China, yet China is catching up. Performance of Chinese products are still lower in general, yet China can win over orders by having lower cost.

        And even in the labor market, many big companies from Taiwan maintain good relationship with Chinese government, and have factories across the strait. If Taiwanese labor markets become too expensive for these companies, then they can simply downsize their operation in Taiwan then hire more people in Mainland China.

        • Borners

          The PRC has a GDP trajectory of Bulgaria, which is actually unfair to Bulgaria given it had an earlier demographic transition, EU emigration and a desire to have holidays; i.e. it higher productivity especially per worker. Also it has had till recently bad geography for high-tech value industrial clusters unlike China.

          The PRC so large that being Mega-Bulgaria translates into a “large” number of high-quality sectors swamped by really unproductive SOE/Real estate/Resource extraction sectors.

          Currencies are tools not assets to the countries that issue them. Both Taiwan and the PRC suppress consumption in favour of increasingly low return exports/investment using different varieties managed floating exchange rate. If your top-end exports require low exchange rates then you have other problems at the high end of GDP (i.e. Italy). For both countries currency values are primarily about maintaining the high-growth-era social balance of power, although the PRC is much more distortionary (see capital controls).

      • Jason

        Taiwan’s export base in manufacturing is diverse and has a very large overlap with China, covering everything from water faucets and bicycles to machinery and LCD panels. While TSMC may have strong pricing power in the chips market, the same does not apply to Giant (bicycles) or any other such similar medium sized enterprises with Chinese competition.

        • Borners

          Taiwan’s problems aren’t export competitiveness. Current Account is driven more by the Capital Account/Domestic savings than “competitiveness” jargon. And given the level of integration in the East Asian manufacturing super-cluster of intermediate goods there is no clean relationship between manufacturing exports and trade/CA surpluses. The US/UK did massive devaluations around 2008 and it did very little good because devaluations increased import costs while not changing the massive inflow of capital from the likes of Germany, Taiwan etc.

          Taiwan should ditch trying to keep the 1990’s and go for a domestic consumption decade based on home-building and remilitarisation backed by imported Indian labour.

          • Phake Nick

            The entire Taiwan inhabit less people than the single city of Seoul. Hence its domestic market really isn’t that attractive. Labor import from Southeast Asia is a thing for Taiwan but I doubt it will help improve the labour market there as imported labour are going to keep the labour cost aka wage low.

  3. adirondacker12800

    non-tradable goods like food
    Have you ever been in a supermarket?
    There is a threat this year’s sunflower crop, in Ukraine, will be much lower than usual. It’s made the world prices of edible oils go up. Indonesia has put export controls on palm oil, to keep prices low in Indonesia. It’s made the world prices of edible oils go up. I’m paying a dollar more for 1.4 liter bottles of anything. Even though anything I can buy, except olive oil, is North American. Ukraine is a major wheat exporter. The price of baked goods and pasta is creeping up. Hope for a really good crop in North America this year. The carton of chilled orange juice says “Florida Squeezed” because it can and does have Brazilian oranges in it…. Where does your coffee or tea come from? And the sugar?
    Have you ever been in a supermarket?

    • Matthew Hutton

      Agreed. We certainly import food in the UK from around the world. Generally that keeps food prices low.

    • Alon Levy

      I have, yes. The vast majority of the food at the supermarket is grown in Europe. Moreover, of the 0.79€ that I pay for a pack of cottage cheese, most of the value doesn’t go to the farmer (who can be anywhere in Europe) but to a supply and distribution chain of truck drivers, packagers, and retail workers, all of whom are local or regional. The result is that staple foods, like a bag of rice or a loaf of bread, cost more here than in India even after PPP adjustment, because retail is a labor-intensive business and it’s impossible for Aldi and Lidl to offshore production to poorer countries the way manufacturers do.

      • Matthew Hutton

        You can buy rice from Tesco in the UK for 45p/kg which is the sort of figure I am seeing at market exchange rates for a kg of rice online in India.

  4. adirondacker12800

    Fresh dairy is very perishable. People are willing to pay premium prices for fresh.
    Most of a supermarket is non-perishable. Which is why it’s sitting on an unrefrigerated shelf. Don’t ask too many questions about where a lot of it was grown.

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