The expensive Pacific

Bunnings Warehouse slogan (Scott Lewis/Flickr/CC BY 2.0)
Bunnings Warehouse slogan (Scott Lewis/Flickr/CC BY 2.0)
Written by Stephen Howes

At a lecture last year to DFAT graduates, I was explaining why developing countries are, as the hardware chain Bunnings claims to be, characterised by lower prices. It’s known as the Penn or the Balassa-Samuelson effect. And it means you can buy more with a dollar in a developing country than a developed one. The economic reasoning is simple: labour costs are lower in poorer countries because wages are lower. Traded goods might be subject to the law of one price (their price should be similar across countries) but non-traded goods are not. Because workers are paid less, restaurant meals, haircuts, and taxi rides are all cheaper in Hanoi than Sydney.

I had a picture to prove my point. In the graph below, with data from the World Development Indicators, each dot represents a country. The horizontal axis shows (on a log scale) each country’s per capita income, measured in US dollars. The vertical one is an estimate of the number of US dollars needed to buy one US dollars’ worth of goods in the country (this is measured in studies of what are called purchasing power parities). Obviously, that value is one in the US. But, as you can see from the graph, it is more than one for many rich countries, and much less than one for poorer countries. In fact, it is only half or less for many poor countries. While there is a lot of variation, on average, purchasing power falls with income: the blue trend line has a positive slope.

In the graph I showed to the students, the dots were all blue. One of my students asked about the group of dots with income between US$1,000 and 10,000 that sits well above the others. It turns out that those countries are nearly all from the Pacific – in the graph above, coloured in orange. It is remarkable how clustered the Pacific countries are on the graph. And how expensive they are, given how poor they are. Pacific countries are fundamentally different to other developing countries in this regard. Only Fiji is anywhere close to the trend line.

Why does the Penn/Balassa-Samuelson effect not hold in the Pacific? Why are their prices so high? One reason is their remoteness and small size. Trade costs are expensive, and even non-traded goods have traded inputs. Electricity is non-traded, but the generator used to produce it needs to be imported. Land is also very expensive in the Pacific.

A second reason is the dominance of aid and in some countries, remittances. These sources of foreign currency push up the demand for domestic currency and/or domestic prices without necessarily raising GDP.

A third reason is the highly dualistic nature of these economies. If you live in the informal sector, prices are cheap (e.g. for the food you grow yourself). But the prices measured here are probably much more representative of the formal sector. Here, prices are often set for multinationals and for aid-funded consultants.

I’m not sure how important each of these three reasons is. But Fiji seems to be the exception that proves the rule. Fiji is larger than most Pacific economies. Aid is not that important (though remittances are). And the Fijian economy is one of the least dualistic of the Pacific. There are few big resource projects.

What can the Pacific do about this? Those countries which have their own currencies could consider devaluation. (No Pacific countries have floating exchange rates.) Some of the gains in terms of competitiveness would be lost via domestic inflation, but by no means all. However, while this may be good policy advice, it is of limited value. For a start, many Pacific islands use another currency: only six have their own. Moreover, urban elites dominate Pacific politics, and will resist depreciation unless there is a compelling argument for it. As there is with Fiji: its reliance on tourism is made possible because its prices are relatively low, and this gives it a strong incentive to keep its exchange rate competitive.

Pacific countries also need to get non-traded costs down, from energy to land to law and order. That would be possible by reform, but it’s a tough reform agenda.

Visitors to the Pacific often comment on the high prices, and others have found that Pacific countries have overvalued exchange rates. But the international perspective is useful, and I’m grateful to the curious DFAT student who asked the question in class. The comparison also shows just how poor some Pacific countries are. Using US dollars, the poorest Pacific country, Kiribati, is only the 48th poorest country in the world. Using purchasing power parities, it is the 20th poorest, and the poorest outside of Africa after Haiti.

Source data here.

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Stephen Howes

Stephen Howes is the Director of the Development Policy Centre and a Professor of Economics at the Crawford School.

7 Comments

  • Fiji’s scenario needs further explanation. This article appears to put Fiji on a pedestal, when in essence, the gap widens between haves & have noughts by hook or by crook post 2006 to 2018.

    Graphs are fanciful. Figures given from home country like Fiji, is questionable. Prefer to see such reports matched with time-line & credit level.

  • Excellent article, raising an important set of issues for Pacific islands. Sustainable development seems likely to proceed only if the overvalued exchange rates can be lowered. And that seems only likely under a market-based approach to be achieved in the long run if the islands invest in financial system and institutional developments that allow nominal exchange rate flexibility and work assiduously to keep real wages low. Not an easy course, but perhaps better than the alternatives.

  • How does New Caledonia and French Polynesia rate? Are French colonies more expensive that independent states?

  • Very nice post Stephen and a powerful graphic. This really highlights the unique challenges facing Pacific economies and the need to develop policies that are specific to them.

  • When I initially moved to PNG, I was surprised to discover that prices were closer to Australian levels, vs Malaysia.

    I also realised that something was missing: no bicycles or motorbikes. Whereas Asia is full of bicycles and motor bikes. I think bicycles and motor bikes helped kick start light industry in Asia. It gave employment, facilitated commerce, and promoted learning and investment.

    It is a mystery why there are so few bicycles and motor bikes. I asked my PNG friends, and they couldn’t give me a good explanation.

  • Interesting also the impact this has on the relatively high cost of aid operations in the Pacific and PNG, especially if a blunt cost-per-beneficiary ratio is being applied. I recall an interesting ethical debate with Peter Singer in the wake of his writings on aid, where he seemed to be implying that if it cost less to save a life in Bangladesh then in PNG then we should all divert our aid funds to Bangladesh. Not sure where this would leave the poor in remote parts of PNG and the Pacific.

  • Really interesting post Stephen. Great graph. You touch on the currency issue, but I’d say that it is very influential factor in Kiribati, Tuvalu and Nauru since they all use the Australian Dollar and therefore can’t have any monetary policy. That, coupled with the high reliance on imports and the inflationary effect that aid and remittances can have in small economies, certainly goes a long way to explaining high prices. I am not up to speed on wage rates, but i know that a number of years ago the average public servant (teacher/nurse) in Kiribati was earning around $8,000 per year. Very difficult to make ends meet when you are paying essentially Australian prices for sugar, flour, rice.

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