One of the
earliest decisions that an analyst confronts is the choice of currency
and price
level in which to conduct the analysis. In principle, analysts
can evaluate
a project in any currency and at any price level. In practice,
they usually
evaluate projects in the domestic currency of the country
implementing
the project at prevailing market prices adjusted for distortions,
that is, at
the domestic price level. These are not the only possible
choices. The
two most frequently used alternatives are domestic currency
at the
border price level and foreign currency at the border price level.
When
analysts use domestic currency at the border price level, they calculate
the prices
of all imports by taking the corresponding cost in the imports’
country of
origin, adding insurance and freight (CIF) in foreign currency,
and
converting it into domestic currency at the prevailing market or official
exchange rate, whichever exchange rate the project entity uses to buy
foreign
currency. Analysts must then adjust CIF prices for internal transport
costs. The
prices of exports are calculated by taking their free on board (FOB)
prices in
foreign currency, converting them into domestic currency at the
prevailing
market or official exchange rate, and adjusting them for transport
costs within
the country. A market exchange rate is used in this context to
mean the
price at which the project entity actually gets its foreign exchange.
The prices
of nontraded goods, such as services, are converted to their
border price
equivalent by means of conversion factors. If the analysis is
done in
foreign currency at the border price level, the prices of imports and
exports
remain in foreign currency. The prices of such things as cleaning
services,
however, are first converted to their border price equivalent by
means of a conversion
factor, and then to their foreign currency equivalent
by means of
the prevailing market or official exchange rate.
If the
analysis is carried out in domestic currency at the domestic price
level, the
analyst calculates the prices of imports and exports at their respective
border
prices, but converts them to their domestic currency equivalent
using a
shadow exchange rate that reflects the opportunity cost of foreign
exchange to
the country. The analyst takes the prices of nontraded
goods and
services, such as cleaning services, at their prevailing market
prices
adjusted for distortions.
The price of
the service (and in general of all nontraded goods whose
market
prices reflect the true economic costs) would be converted as follows.
If we use
domestic prices at the domestic price level, the price of the
service
would be taken as given. If we use domestic currency at the border
price level,
we would need to calculate the border price of the service by
using a
conversion factor. In this case, the appropriate conversion factor
would be the
ratio of the official to the shadow exchange rate, 0.88. If the
numeraire is
foreign currency at the border price level, the border price in
domestic
currency would have to be further converted to dollars using the
market
exchange rate.
The choice
of currency and price level is largely a matter of convenience
and will
have no impact on relative prices or on the decision to
accept or reject
a project. for example, the price of the imported
good
relative to the price of cleaning services is 2.5:1 in all cases. As
long as
relative prices are unaffected, if the NPV of a project is positive in
one case, it
will be positive in all cases. Moreover, the NPV measured in
domestic
currency at the domestic price level will differ from the NPV
measured in
domestic currency at the border price level by the ratio of the
market
exchange rate to the shadow exchange rate, that is. Therefore, one can quickly
convert the NPV from one numeraire to another. The internal rate of return
(IRR) remains the same, regardless of numeraire.
In most
countries, the domestic price level is the price level used to
keep
national accounts, the price level used by the government to reckon
its taxes
and expenditures, and also the price level used by business. One
usually
conducts financial analysis in domestic currency at prevailing market
prices. To
integrate financial, fiscal, and economic analyses; to assess
risk and
sustainability; and to identify gainers and losers, the analyst must
express the
financial and economic analyses in the same unit of account.
When the
financial analysis is performed in one unit of account and the
economic
analysis in another, the differences between the financial and the
economic
values have no meaning. Because we generally conduct financial
and fiscal
analyses in domestic prices at the domestic price level, it is most convenient
to carry out the economic analysis in the same unit of
account. If
we use the border price level for the economic analysis, the
fiscal
impact of the project would need to be calculated twice, first at the
border price
level and then at the domestic price level. Moreover, for the
evaluation
of projects with nontradable benefits, for example, projects in
education,
health, and transportation, it is much easier to evaluate the benefits in
domestic currency at the domestic price level than in some other
numeraire.
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