In my blog from December 2018 – Is the advanced East as rich as Southern Europe? – I tried to flash out why it is worth looking at nominal variables alongside the real ones when gauging the state of convergence of the Eastern European countries to the developed West. This blog argues that nominal figures are overlooked in many cases also in some other contexts.

Let’s take a simple question: Which is the biggest economy in the world? Is it still the US or has China overtaken? The answer depends on which figures one looks at. According to the official IMF statistics of the gross domestic product (GDP) in 2019 in nominal figures, the US still is the biggest economy, its GDP was 21 439 bn USD while that of China was only 14 140 bn USD (even the economy of the EU was bigger than the Chinese one, its GDP in nominal prices was 18 705 bn USD in 2019). However, given that prices of goods and services in China are typically much lower than those prevailing in the US when adjustment is made for differences in prices ( re-calculation based on so-called Purchasing Power Parity metric), the Chinese economy is the world’s most productive with the GDP based on PPP 27 309 bn USD while that of the US is 21 439 bn USD ( the US is a base country for PPP calculations). In a nutshell, the US has the world’s biggest economy in nominal USD terms while China prides the world’s most productive economy based on the PPP recalculation.

Which set of numbers is more relevant for policy analysis? Figures adjusted by PPP suggest how productive the real economy is in terms of produced goods and services – hence the given figures for the Chinese economy suggest that China has the most productive economy in the world in terms of real output. However, when we would intend to calculate the size of the economy in terms of “the sheer economic mass” – perhaps to suggest how economicly powerful the individual countries are – then nominal figures might be more useful. In other words, the actual world in which we live is nominal: wages, prices of goods, sales or capex of firms, macro- capital flows or debt all are nominal variables. Economic figures adjusted for price differences are an artificial construct of economists. While they might be useful for economic modeling and analysis, an individual does not observe them in the real world.

Since we are using the figures of IMF, an additional small comment might be useful here. According to the World Economic Outlook, the world’s GDP growth projection for 2020 is 3.3 %. This is just illustration – this figure is now probably obsolete and given the current unfolding crisis it will be much lower. However, the real question is as follows: Is this the projected growth of the world economy by the IMF in PPP, constant prices or is it a growth of the world’s nominal GDP (in USD)? While the Fund in its headline communique does not say so explicitly, from other IMF outputs it can be inferred that it is a figure based on GDP growth in constant prices of individual countries. Many companies in the world and its planners who prepare company-level projections might compare the growth of their relevant world market with this headline figure. However, the relevant figure should be the growth of the world’s nominal GDP, not the real one. This is because corporate-sector planners work with sales figures in nominal terms recorded in the actual world.

How high is then the growth of the world’s nominal GDP in normal times? Probably significantly higher than the current projection of 3.3%, given a high nominal GDP growth in China and other emerging market economies and existence of inflation nearly everywhere(nominal exchange rate fluctuations vis-a-vis the dollar obfuscate otherwise straightforward calculation). A little speculatively, the world’s nominal GDP growth in USD could be 1-2 % higher than the figure based on the constant prices, in normal times.

One last comment of somebody who has prepared company valuations before. When valuing a company, say with global sales, using a discounted cash-flow framework one splits projection into two stages – an explicit projection phase and approximation of terminal value using the so-called Gordon growth formula. However, where do we cap the growth of a company’s cash-flow in the terminal value formula? Clearly, the rate of growth of the company’s cash flow in perpetuity must be below the cost of capital, otherwise, the model is invalid. Additionally, in the Gordon growth formula, the permanent growth of the cash-flow of a firm should be further below the projected long-term growth of the world economy, lest the company would overtake the whole world in an infinite horizon. However, which growth rate of the world economy shall we use as a ballpark of the upper limit? In the author’s opinion – since everything in the cash-flow model is in the nominal figures – the relevant ceiling is the rate of the growth of the world economy in nominal terms (let’s say, in USD), rather the growth rate based on constant prices.

Does this imply that some market participants might systematically undervalue assets?

Vladimir Zlacky
8 April 2020

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