What are Geary-Khamis or International Dollars?
How Economists Use International Dollars
Currencies are commonly quoted relative to each other in the foreign exchange (“forex”) market. For example, a 1.2500 quote for the EUR/USD currency pair means that one euro is exchangeable for 1.2500 U.S. dollars. The problem with using exchange rates is that they aren’t adjusted to reflect purchasing power parity (“PPP”) or average commodity prices within each country.
Roy C. Geary created the Geary-Khamis dollar, or international dollar, in 1958 to reflect the current year’s exchange rate with current PPP adjustments.
Since its introduction, the international dollar has become the metric of choice for international organizations like the International Monetary Fund (“IMF”) or World Bank for comparing wealth and earnings between countries.
What is Purchasing Power Parity?
Purchasing power parity was developed in the 16th century to determine the relative value of different currencies and set exchange rates. In theory, identical goods would have the same price in different markets when prices are expressed in the same currency absent of transaction costs and trade barriers. Similarly, any differences in inflation are equal to the changes in currency exchange rates.
Of course, transaction costs and trade barriers exist in real life since exchange rates aren’t always equal to one. Economists must therefore recalculate currency exchange rates accounting for purchasing power parity differences caused by these transaction costs and trade barriers.
These calculations are ultimately what are known as Geary-Khamis dollars or “international dollars”.
Converting to International Dollars
Currency conversions to international dollars are accomplished by dividing the amount of national currency by the PPP exchange rate to arrive at the international dollar value.
For example, 500,000 ISK (Icelandic Krona) divided by a 121.91 PPP exchange rate yields I$ 4,101.38. PPP exchange rates are provided by a number of different international organizations including the IMF and World Bank.
The PPP exchange rate, or PPP conversion factor, is the number of units of a country’s currency required to buy the same amount of goods and services in the domestic market as a U.S. dollar would buy in the United States. Basically, these figures help investors compare the cost of goods that make up gross domestic product (“GDP”) across many different countries relative to the United States.
Importance of International Dollars
International dollars have become extremely important in a world where currency exchange rates are commonly manipulated. For example, the World Bank estimated in 2005 that one international dollar was equal to about 1.8 Chinese yuan, which was considerably off from its nominal exchange rate. A failure to account for these changes could lead to a dramatically different perception of China’s economy.
Purchasing power parity differences can also be quite extreme when it comes to GDP per capita or other measures. For example, India’s nominal GDP per capita was $1,491 in 2012 while its PPP GDP per capita was $3,829.
International investors can use international dollars as a way to quantify currency risks and determine how over- or under-valued a currency is compared to an 'intrinsic value'. In the example above, investors might conclude that the Chinese yuan is considerably undervalued and may want to consider a hedge against a rising valuation over the long-term if it's at risk of normalizing.
A similar measurement of a currency's true value is the Economist's Big Mac Index, which is also based on purchasing price parity. But instead of arbitrarily calculating the difference in prices, the company uses the price of a McDonald's Big Mac, which are sold around the world.
The ubiquity of the burger makes the measurement uniquely suited for calculating a currency's relative value.
For instance, suppose that a Big Mac in the U.S. costs one dollar and in the eurozone costs two euros. The Big Mac Index valuation for the EUR/USD would be 2.0, or two euros divided by one dollar, which could then be compared to the official exchange rate. A value that's lower than the official rate could suggest that the currency is undervalued and vice versa for an overvalued currency.
Other groups have created similar comparisons using everything from Apple iPhones to Starbucks coffees, since they are products that are widely sold throughout the world. While some of these metrics may be of limited use, and are merely vanity measurements, international investors may want to consider using the most accurate measurements.