Beyond the burger

By bne IntelliNews July 5, 2011

Ben Aris and Tim Gosling in Moscow, Clare Nuttall in Almaty -

"Imagine the scene. A warm spring evening in Istanbul. A gentle breeze drifts in off the Sea of Marmara as residents start to gather in the bars and restaurants of the fashionable Nisantasi quarter. You choose a small, unassuming bar and order a cocktail to finish the day. So far, so good... but then the bill comes: 18 Turkish lira for a gin and tonic. At the current exchange rate, this equates to a bit over US$12. $12? You would be hard pressed to pay this sum in most bars in New York City. In London's West End, Corney & Barrow charges $11.50 (£7.00) for the same drink," Andrew Howell and Maria Gratsova, London-based analysts for Citigroup, write in a recent note on currencies in Central and Eastern Europe.

Overpriced drinks are a well-known phenomena for anyone who has travelled in Central and Eastern Europe during the last decade. The country in question might be falling to pieces, but the visitor is quite used to getting murdered on the bar bill, the restaurant bill, the hotel bill - in fact, for pretty much any "western standard" service you care to mention.

The lack of competition and the avarice of high-end service providers like posh hotels go someway to explaining the price difference - but not all the way. Just why are so many things in emerging markets so expensive? After all, Turkey's GDP per capita is 72% lower than in the UK, and 77% lower than in the US. Even assuming that wealth is more concentrated in places like Turkey and Russia than it is in the UK and US, does it make sense that a coffee in Istanbul and Moscow should be more expensive than it is in London or New York?

The starting point for these discussions is, of course, currency rates. As the global economic crisis recedes, it has left a world where the emerging markets are in much finer fettle than the developed markets, meaning their currencies have generally rebounded against the US dollar, sterling and the euro.

This should come as no surprise. Since the end of the gold standard, the value of floating currencies is determined by a cabalistic combination of a country's hard currency reserves, its basic macroeconomic position (the size of its debt and deficits), its economic output and the expectation of its future economic performance. From this perspective, the fact that many big western economies have gone from powerhouse to paralysis of course means that the value of their currencies is falling. On the flip side, most of the economies of Emerging Europe have come out of the crisis leaner as leverage in the system was squeezed out, and so the relative value of their currencies is rebalancing.

To see how far those currencies have recovered and whether they have overshot or undershot, economists look at purchasing-power parity - the notion that a dollar should buy the same amount in all countries, so that over the long run the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country.

The most famous example of this theory in practice is The Economist's Big Mac index, which uses the McDonald's ubiquitous burger as "the basket". The Big Mac is (virtually) the same in the roughly 120 countries in the world in which it's sold and so should, in theory, cost the same everywhere.

Looking at the latest Big Mac index, released in October 2010, this burger is cheaper in all the CEE countries than in the West, except in Turkey. However, between 2000 and 2010 that gap has been closing, with the discount narrowing from 41% to 21% over the period. This in line with the assumption that as the emerging markets develop, their currencies rise, as well as the greater recovery seen in those countries since coming out of the recent crisis.

And all the evidence suggests this gap has narrowed further since the last Big Mac index, not surprising given that over the period the Hungarian forint has risen about 18% against the dollar, the Czech koruna 14%, the Polish zloty 12% and the Russian ruble 9%.

Beyond the Big Mac

Fun as the Big Mac index is, it is only a guide to the relative value of currencies and doesn't give a true reflection of the pricing environment in a country.

For example, the cost of a Big Mac in the McDonald's on Prospekt Nezavisimosti in Minsk is BYR13,400. At the current exchange rate of BYR4,972.00 to the dollar, the cost of a Big Mac is $2.70, against the London price of $3.77. This is way down from $4.46 a Big Mac cost at the start of January this year, when the currency was clearly overvalued. The Belarusian ruble has been going through a series of devaluations this year, but even at $2.70 the Belarusian Big Mac still looks pretty expensive compared with the Big Mac in Moscow, which costs $2.64, or Kyiv, which cost only $1.80.

And the black market currency traders that have reappeared on the Minsk streets since the government clamped down on foreign exchange trading in recent months agree: they are asking for BYR6,000 to the dollar, which would make the cost of a Big Mac $2.20. In other words, the speculators think the Belarusian ruble is still overvalued, whereas the Big Mac index suggests it is undervalued.

The picture is further muddied by the GDP figures: Belarus' GDP expanded 12.3% on the year in January-April - the fastest growth in the Commonwealth of Independent States (CIS) - but the World Bank said in June that the economy will slow to finish the year with just 2.5% growth. The strong growth suggests the currency should rise, but the expectation of a slowdown suggests it should fall.

Citigroup's Howell and Gratsova find similar problems with the cost of a Big Mac in Russia. "The $2.33 for a Big Mac in 2010 ($2.64 at last check) is on the cheaper side, which is hardly consistent with the impression one gets at a Moscow shopping mall. Clearly, McDonald's products are positioned and priced differently in different countries, so the signals from this index can be misleading," the analysts say.

On the other hand, the Big Mac in Turkey is one of the most expensive in the world at $4.63. So what is really going on?

Under the lettuce

To get a better picture, Citigroup looked at a broader range of goods that should give a more accurate reflection on what things cost across the region. The basket is made up of 22 items covering a mix of food and beverages, transportation, leisure, "personal items" and real estate. Current prices for all of these goods were gathered for five big emerging market cities - Moscow, Istanbul, Dubai, Johannesburg, Warsaw (bne has compiled data for Almaty and Kyiv and added it to the table) - plus London and converted them to dollars. The right-hand columns of the table display each city's price as a percentage of the London prices in "heat map" form, with the cheaper items shaded in blue and the more expensive items shaded in red.

The authors admit that their broader index still suffers from major shortcomings. For example, the price level of the capital may not be fully applicable of price trends in the country more broadly. "It goes without saying that the cost of living in Moscow or Istanbul is not fully representative of the cost of living elsewhere in, say, Perm or Kayseri," they note.

Even so, a quick glance shows that this "Beyond the Burger" basket probably gives a truer picture of the currencies and price trends than the Big Mac index. While consistent with the Big Mac index the Turkish lira is overvalued and the Polish zloty undervalued, this basket shows the ruble is indeed overvalued as anyone who's been to Moscow would expect. "Based on what Moscow prices are telling us, the ruble does looks expensive," Citigroup analysts say. "It seems that the Big Mac really is misleading... The recent weakness of the lira down 5% versus the dollar since last October, versus 9% for the ruble and rand, has not done much to dent Istanbul's 'expensiveness'."

However, what's most striking about the table is the mix of expensive and cheap prices in each city is not the same. If the difference with London prices were purely a question of the currency value being wrong, then all the relative prices in each country should be the same: an expensive pair of shoes in Moscow should be just as expensive in Almaty, but they are not. Clearly, there are many other factors at work to make emerging market capitals so expensive for so many goods.

Friction and greasing palms

Working out all the factors that go into making prices is a question of guesswork, as the market is only responsible for some of the most important influences.

The most obvious difference between countries that affects the costs of goods and services is what the economists refer to as "friction." The simplest of these is transport costs. A pair of Nike trainers in Almaty costs 177% of those in London, because Almaty is about as far from the rest of the world as it's possible to be, so transporting anything there costs a lot.

The differences in import duties and local taxes also distort prices. For example, the duties on imported cars to Russia can run to 100% and so double the cost to the punter. The upshot is a thriving trade of Tajik residents of Moscow trooping off to Berlin to buy cheap second-hand cars, which they then sell in Moscow for double the price.

Probably the most significant non-transparent input to prices is corruption. The customs services across the whole of the CIS is notoriously bent and a huge industry has sprung up around the ability to reclassify goods like Prada shoes as humanitarian aid. "I recently paid $500 for a five-hour flight from Moscow to Madrid in economy class on Iberia Airlines. Before that, I paid about $950 for a three-hour flight from Novosibirsk to Chita. The math is simple: domestic flights cost two to three times what comparable flights abroad cost," Yulia Latynina, a famous Russian columnist and radio host on Ekho Moskvy, wrote in her column recently, concluding that graft adds at least 50% to the cost of nearly everything in Russia.

In Russia, "everyday" bribery has doubled over the last decade, according to the Economic Development Ministry. Russians paid at least RUB164bn ($5.9bn) in 2010 to buy off teachers, traffic policemen and others in "everyday" situations. And Russian businessmen lead Europe in terms of backhanders. A report from Ernst & Young in May found that 39% of Russians were willing to pay a bribe to win a tender or "settle affairs."

The problem doesn't just afflict Russia. The same survey found about a quarter of Turkey's businessmen also admitted to paying bribes, and Turkey leads in giving expensive gifts to counterparties to help deals go through: 32% of respondents admitted to giving expensive presents to business partners, ahead of 26% in Russia.

And Ukraine was singled out for criticism by the head of the Organisation for Economic Co-operation and Development's (OECD) corruption monitoring agency in June. "With regard to the fight against corruption, Ukraine is trailing the pack among all the countries of a transitional type," Goran Klemencic, chief commissioner of the Slovenian Commission for the Prevention of Corruption, told a Ukrainian parliamentary committee meeting on corruption in May, adding that of the 24 recommendations on fighting corruption given to Ukraine in 2004, only one has been carried out.

However, calculating the cost of corruption is by definition extremely difficult, although the problem seems to be getting worse, thanks to the increased pressure on business following the global crisis: 81% of respondents to the survey said corruption has increased in the last two years.

Ironically, the cost of corruption is getting so high that anecdotal evidence suggests that in some business spheres it's becoming cheaper to pay the official import duties than grease the palms of an increasingly long line of greedy officials. Coupled to this is the state's efforts to clean up some sectors: according to bne's recent interview with the founder of Rolf, Russia's largest car dealership, most of the car imports to Russia are now done legally, while the state has quietly cracked down on consumer electronic imports to close down the duty-dodging grey schemes.

Novelty items

Friction and graft are pretty obvious factors that distort prices, but less obvious is the simple novelty of many goods. For example, Poland is a member of the EU and so operates under the EU trade regime. In general, Warsaw is one of the most inexpensive cities in the Citigroup survey, but some items - new things like trainers and painkillers - are not.

Open borders, a simple import regime and arbitrage should cause prices to convergence, but this misses the novelty factor and the role that competition plays. As pointed out, posh hotels in Moscow charge exorbitant prices; a room at the Ritz Carlton in central Moscow can cost over $1,000 night and the hotel has reported 95% occupancy rates for every month this year, according to another bne survey. The Ritz Carlton gets away with these ridiculous prices thanks to the prestige factor, which attracts the richer slice of Moscovites looking to treat themselves and show off. The same is true for a cup of coffee: a tall latte is one of life's little (and affordable) luxuries, so ordinary Muscovites, just like the oligarchs, are willing to pay over the odds for this treat.

Part of this willingness to pay more than in western capitals for goods has to do with underdeveloped brand awareness. Inundated by advertising since birth, westerners grow up with a fairly well defined scale of the worth of goods. For many in Emerging Europe, however, the main indicator of a brand's value is its price. "When we started to import Naf Naf clothes, they didn't sell very well - so we doubled the prices and they sold much better," a Naf Naf franchisee tells bne. Likewise, the Irish supermarket that used to stand opposite the Kremlin had a sign on its door: "Shop at the weekend: everything 25% more expensive."

Tastes are still evolving, as typified by the transition from track suits, to shell suits, to Armani suits that most of the well-to-do have gone through through over the last two decades. It is only now after buying houses in London and Berlin that the rich are starting to develop any taste of their own. The hoi polloi are much further behind when it comes to the choice of goods on offer: McDonald's has been operating in Russia for over 20 years, but Wendy's and Burger King both only entered the market in June.

The governments of the region are also doing their bit. While it is natural that prices are free for non-essential items like Nike trainers, governments have been deliberately holding down the prices of staples like milk and that basic insurance against disaster: potatoes. Dachas still account for almost half of the agricultural production of most of the countries of Eastern Europe with potatoes the most important crop. Central planning is dead, but governments have resorted to administrative means and simply browbeating producers to hold down the price of goods like milk and flour during the food inflation hike in the summer of 2008, afraid of bread riots. But the same lack of controls means these prices can't be held down indefinitely and in Moscow milk prices rose last year back to market levels after the inflation spike passed.

Likewise, the lack of reform can be seen in some sectors where Soviet-era distortions remain. Passenger rail tickets are still cheaper than commercial tariffs in most countries of the region, as is the cost of electricity, whereas the opposite is true in the West. But this is changing too, as Kazakhstan, and to a lesser extent Russia, has passed on the cost of reforms to the postal service to customers. And prices for petrol, gas and power are rising steadily across the region.

Still, the lack of progress with reforms is still represented in prices. Ukraine stands out on the price comparison basis as one of the consistently cheapest places in the CEE region, home to the cheapest Big Mac at $1.80 a munch, or 47% of the price in London. Almost all of Ukraine's prices are extremely low, which is a reflection of the state of perennial crisis in the country over of the last six years that has stymied reform. State services are still close to Soviet levels, with the cost of sending a letter at 19% of London prices and a bus ticket at 11%. Likewise, the cost of staples like flour, potatoes and milk are all also by far the cheapest in the peer group (which is also a function of its flourishing agricultural sector). In fact, the only thing that is expensive, according to bne's survey of prices, are shoes, which cost a little bit more than they would in London.

Kazakhstan is further advanced than Ukraine and many of the prices for goods in Almaty are close to their London equivalents (although there are no McDonald's restuarants at all). But like many other CIS countries, potatoes are extremely cheap, while local services and even real estate prices are all rock bottom.

And finally there is plain old monkeying about with the exchange rate to promote growth, something many of the EU members would love to do, but can't because they are members of the euro. "In Kazakhstan, the current exchange rate is comfortable for exporters, who are the main contributor to economic growth under the current economic model. The government is targeting 7% growth for this year, and a weaker currency will help to achieve this," says Kassymkhan Kapparov, an analyst with Renaissance Capital.

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