Purchasing Power Parity – The Smart Way to Buy in China

October 14, 2008 Posted by China Briefing Reading Time: 3 minutes

CHICAGO, Oct. 14 – With the United States likely to fall into recession during the next couple of years, now is a good time to evaluate purchasing polices from emerging markets as the household pinch on buying products extends up the supply chain to the source of product—in this case, China (although this perspective can also be applied to other currencies such as those in Mexico, Brazil, India, Russia).

Purchasing power parity is the art of recognizing the true value of the local currency, and applying that to buying techniques. Let’s take for example, the U.S. dollar and the RMB. According to conventional wisdom and current exchange rates, the U.S. dollar is valued at US$1 = RMB6.8. In fact, the two currencies are rather more similar than is commonly acknowledged.

Both currencies have the unit of 100 as their largest denomination. Both feature pictures of deceased leaders. Both are the most sought after valued note in their respective nations. Yet, according to the current exchange rates, the RMB100 is only worth about US$15 (give or take a few cents). Yet purchasing power parity holds that in China, the RMB100 note will buy the same quantity of goods or services as the US$100 will in America; in which case, the two notes are essentially identical in their respective domains concerning their ability to purchase.

Let’s look at a couple of scenarios. A few weeks ago, I was lecturing to a group of prominent Chinese businessmen, all highly successful, and all Peking University alumni (the Ivy League of China). They were all multi-U.S. dollar millionaires in their own right, with very successful businesses in China and overseas. I asked one of them, a Mr. Wang, how much he had paid for his last haircut in China. He looked a bit shamefaced, and blurted out “RMB30” (about US$4.5). His colleagues all laughed. Yet the point is that he looked mildly ashamed, not because his haircut was cheap, but because he had paid too much. He knew his colleagues knew it, and had laughed at him for being so wasteful. When asking others in the same group how much their haircuts had cost, the average cost turned out to be RMB5—less than one dollar. The unfortunate Mr. Wang had been paying way over the odds for a simple service in his own country.

In another scenario, I recall visiting with a client with a factory in a small city about 200 kilometers west of Shanghai. To attract foreign investment, the local government had built the best hotel in town; a Chinese-run 4-star facility. We stayed there one night, and as we checked out, my client remarked on the size of the bill, which had run to RMB200 (about US$30) for the night. “I can see why China can manufacture cheaply,” he said. “With overheads like these there is no way the U.S. can compete. The hotel is actually very nice and for sure I cannot get a hotel for US$30 a night back in the States”.

I noticed that some of his Chinese managers, also visiting with him, had not stayed at the same hotel. Speaking to them later in the day, they confessed they’d preferred to stay in a similar hotel, but a bit further down the road. “The hotel we stay in costs RMB90 (US$13) a night,” they said. “We don’t want our bosses to feel we are being wasteful with the company money.”

Herein lies the crux of the matter, when purchasing in China, perceptions of currency need to change from being US$ dominated to being RMB dominated. RMB100 can buy, in China, roughly the same value of goods and services as US$100 can in the States. Wise purchasing managers will recognize this and look to instruct staff to fully understand the real value of China’s currency. Because if looking to compete with Chinese manufacturers while remaining US$ purchasing focused will never be enough, in terms of currency perception, to be able to compete on the same playing field.

Chris Devonshire-Ellis is the senior partner of Dezan Shira & Associates and the publisher of China Briefing. This article is excerpted from his speech to the Loyola University Chicago School of Law, at their U.S.-China Business Forum this coming Wednesday, October 15. Readers wishing to attend the full day event may download details here.