ppi and measuring inflation in business transactions

7/29/2019 PPI and Measuring inflation in business transactions

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The 20th Annual Conference on Statistics & Modeling in Human & Social Science

PPI and Measuring Inflation in Business Transactions in Egypt

Abdel-Hameed Hamdy Nawar

Faculty of Economics & Political Science, Cairo University, Giza 12613, Egypt

Abstract. This paper discusses and analyzes selected pertinent statistical and economic ques-tions raised by the shift in price statistics towards covering broader markets of the economy,namely introducing a Producers Price Index (PPI) series in place of the Wholesale Price Index(WPI) series in Egypt since the beginning of 2008. The paper discusses the price index gapin Egypt and the methodology employed in constructing the newly-introduced PPI. The paperproposes tackling several characterized problems concerning the construction and quality of PPIstatistics in light of e-commerce and globalization, existing limited coverage of service sectors,and improper indices for cost escalation and contracting. The paper also proposes devising a

core inflation measure for inflation targeting in Egypt.

Mathematical Subject Classification: 62P20; 91B82; 62M10JEL Subject Classification:C43; C81; C13; E31;L16.Keywords: Price statistics, Index number, Laspeyres Formula, PPI, Inflation-targeting.

1. Introduction

A price index is an index number that measures the change in the average prices p1 ofa basket of goods and services of fixed quantity and quality in a certain period of time -

usually month, or year - compared with the average prices of the same basket in anotherperiod called the base period prices, p0. The basket is divided into sets and subsets, eachof which has a relative importance called weight.

In price statistics, consumer price index (CPI), wholesale price index (WPI) and theproducer prices index (PPI) and Employee Cost Index (ECI) are most common.

Price index statistics compactly summarize the state of the economy. Useful uses of priceindices include (1) measuring changes in the prices of goods and services; (2) providingeconomic indicators of inflation; (3) deflating output for national accounts; (4) spatialprice comparisons; (5) intertemporal comparisons between input and output prices; (6)instrumental for monetary policy controls; and (7) tool for economic analysis that closely

reflects the market supply and demand conditions.

Price indices in Egypt have witnessed several developments in recent years. Namely, theCentral Agency for Public Mobilization and Statistics (CAPMAS) started as of January2007 releasing a new series of the CPI. In addition, a shift in wholesale price statisticstowards covering broader markets of the economy is taking place, namely a ProducersPrice Index (PPI) series is released to replace the WPI series since the beginning of 2008.The expanded coverage of the markets takes into account the services activities


2/20Electronic copy available at: http://ssrn.com/abstract=1106416

PPI and Measuring Inflation in Business Transactions in Egypt 1

This paper addresses the PPI and the measuring of inflation in the prices of transactionsbetween businesses in Egypt. The paper is organized as follows. In the next section somepreliminaries and notation of the index number theory are reviewed in order to underlinethe various index formula and their desirable properties from both statistical and economicpoints of view. Section 3 provides an overview on the price indices in Egypt, namely theCPI and the discontinued WPI series in order to shed light on how and why their ratesof change may differ over time. Section 4 characterizes and discusses the price indexgap in Egypt. The development of the PPI and the most important characteristics of itsconstruction and coverage are discussed in section 5. Several problems of the PPI areaddressed and analyzed in section 6. Section 7 concludes a number of recommendationsto activate the role of the PPI in policy considerations in Egypt.

2. Preliminaries and Notation of the Index Number Theory

The calculation of price indices proceeds in two stages: (i) turning all collected pricesinto elementary price indices, and (ii) combining elementary indices to obtain higher-level

indices using the information on each elementary aggregate as weights.

1

2.1. Elementary Price Indices. Sample prices for every homogenous set of items,m, m = 1,...,M, defined within the industrial classification -a.k.a. elementary aggregates-are used to estimate elementary, i.e. not quantity- or value-weighted, price indices. Op-tions for constructing elementary indices include:

Dutot Index:

PD(p0, p1) =

Mm=1

1

Mp1m

/

Mm=1

1

Mp0m

= M

m=1

p1m /M

m=1

p0mCarli Index

PC(p0, p1) =

Mm=1

1

M

p1m/p

0m

Jevons Index

PJ(p0, p1) =

M

m=1

p1m/p0m1/M

Harmonic Index

PH(p0, p1) =

Mm=1

1

M

p1m/p

0m

1

1

1For more discussions and explanations, see the IMF Manual [ 8].


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2 Abdel-Hameed H. Nawar

Additionally, the Carruthers-Sellwood-Ward-Dalen index is a geometric average of Carliand Harmonic indices:

PCSWD (p0, p1) = [PC (p

0, p1)]1/2 [PH (p

0, p1)]1/2

Theorem 1. For two price vectors p0

= (p0

1, p0

2,...,p0

M) and p1

= (p1

1, p1

2,...,p1

M) andunder normal economic conditions, when the price ratios pertaining to the two periodsunder consideration are negatively correlated with the corresponding quantity ratios, itcan be shown that: 2

PC PJ PH

2.2. Higher-Level Indices. For two quantity vectors q0 and q1 of a specified specifiedquality, the elementary price indices are combined with quantities as weights to obtainhigher-level indices. Options for constructing higher-level indices include:

Laspeyres Index:

PLp0, p1, q0, q1

=

ni=1

p1i q0i

nj=1

p0jq0j

, for i, j = 1,...,n

Paasche Index:

PPp

0

, p1

, q0

, q1

=

n

i=1p1i q

1i

nj=1

p0jq1j

, for i, j = 1,...,n

Define the period t revenue share on product i as follows:

sti =ptiq

ti

nj=1

ptjqtj

, for i = 1,...,n and t = 0, 1

Then, the Laspeyres index, can be rewritten as follows:

PLp0, pt, q0, qt

=i

s0iptip0i

, for i = 1,...,n and t = 0, 1

2It is noted that each of the three indices PC,PJ and PH is a mean of order r, where r equals 1, 0 and-1 respectively and so the inequalities follow from Schlomilch inequality. The strict inequality will holdprovided that the period 0 vector of prices, p0, is not proportional to period 1 vector of prices, p1. Fordetailed proof, see Chapter 20 in [8].


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The Laspeyres and Paasche indexes tend to diverge. Irving Fisher [ 6] defined a geometricaverage which has come to be known as Fisher ideal index, PF:

PFp0, p1, q0, q1

=

PLp0, p1, q0, q1

1/2

PPp0, p1, q0, q1

1/2Theorem 2. For two price vectors p0 = (p01, p

02,...,p

0n) and p

1 = (p11, p12,...,p

1n), and

two quantity vectors, q0 = (q01, q02,...,q0n) and q1 = (q11, q12,...,q1n), pertaining to the twoperiods 0 and 1, under normal economic conditions, when the price ratios pertainingto the two periods under consideration are negatively correlated with the correspondingquantity ratios, it can be shown that: 3

PL PF PP

The concept of pure price index based on pricing out a constant representative basket,with hybrid shares si corresponding to the quantity weights vector q is defined by Loweprice index:

PLo (p0, p1, q) =

ni=1

p1i q

nj=1

p0jq,

=i

sip1ip0i

, for i, j = 1,...,n

where si = p0i q/

nj=1

p0jq, for i = 1,...,n. Obviously, both the Laspeyres and Paasche

price indices are special cases of the Lowe price index for q = q0 and q = q1 respectively.

However, practically, q can be selected differently by the statistical agency.Alternative approaches to index number theory including the fixed basket approach,

stochastic approach, axiomatic approach, economic approach and divisia approach haveconverged substantially over the past quarter of century and give guidance on the rea-sonable price index properties.4 Taking the axiom approach, the reasonable price indexproperties include (1) positivity, (2) continuity, (3) monotonicity in its arguments, (4) in-variance to proportional changes in its arguments, and units of measurements, (5) weightsymmetry (6) mean value axiom, and (7) time reversal axiom. The latter axiom is oftenevaluated in the index number frameworks.5

Axiom 1. (Time Reversal Axiom) The index number P(p0, p1, q0, q1) satisfies the

time reversal axiom if: Pp1, p0, q1, q0

Pp0, p1, q0, q1

= 1

3For proof, see Appendix of Chapter 15 in [8].4See [5] for discussion.5In fact, the IMF Manual on PPI lists 21 axioms for the price index numbers, which are detailed in

Chapter 15. See [8] for discussion.


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This axiom simply says that if the period 0 and period 1 price and quantity data are in-terchanged and the index number formula is evaluated, then this new index P(p1, p0, q1, q0)is equal to the reciprocal of the original index P (p0, p1, q0, q1). Putting it another way,the index number comparison between any two points of time should not depend on thechoice of which period we regard as the base period It can be shown that both PL andPP do not satisfy this axiom, while PF does. Moreover, for the elementary indices, whereno quantity or value weights are available, it can be verified that PD, PJ and PCSWD sat-isfy the time reversal axiom. PC, fails this test with the product 1 and will generallyhave upward bias while PH fails this test with the product 1 and will generally havedownward bias.

3. A Brief Review of Price Index Numbers in Egypt

In Egypt at the elementary level, the Jevons geometric average index is used while athigher level aggregation some pure price index based on pricing out a constant represen-tative basket, e.g. Laspeyres index or Lowe index is used.

3.1. Consumer Price Index (CPI). The CPI in Egypt tracks final consumer prices inboth urban and rural areas as well as all Egypt. The sections included in the CPI areclassified in accordance with internationally established guides such as the Classificationof Individual Consumption According to Purpose (COICOP 2003) and the UN Systemof National Accounts issued in 1993. It includes 12 groupings covering both goods andservices. The latest series has January 2007 as the base period. The quantity weights ofthe CPI basket are derived from the 2004/2005 Household Income, Expenditure and Con-sumption Survey (HIECS) and updated to be more reflective of the current consumptionpatterns. The Food and Beverages has weight equals 43.9%, Rent, Water, Electric-

ity and Fuel has weight equals 13.5%, and Clothing and Footwear has weight equals7.9%. These three groupings together comprise about two thirds of the total weights ofthe basket of the index.

The CPI for the urban areas is released monthly, while that for the rural areas and allEgypt is released every two months. As data in Table (1) shows the annual CPI inflationin urban areas reached 10.5% in January 2008 compared to 6.9% in December 2007, whilethe inflation rate for food and beverages reached 13.5%.

Table (2) presents the data for the annual inflation rate in January-January 2008 inrural, urban and all Egypt. The headline inflation in all Egypt reached 11.5%, and 12.8%in the rural. For the Food and Beverages, inflation rate reached 16.2% in all Egypt and

18.9% in rural areas.

Because it relates to the daily cost of living of the people, the inflation rate is one ofthe most important issues of concern to the attention of public opinion. Some observers,however, view that the measure of inflation according to the CPI is not realistic. Twoprominent Egyptians recently strongly questioned the Government statistics for infla-tion; the first in the Egyptian newspaper Al-Ahram , Dr. Hazem El-Beblawi, writinghis thoughts reflecting on Darrell Huff s book How to lie with statistics , [ 7] where


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Table 1. CPI Urban 2007, January 2007=100

2007 2008

Groupings Weight Sep Oct Nov Dec Jan Feb

All ITEMS 100 105 106.1 105.9 106.3 110.5 112.5

Food, beverages 43.9 110.7 108.7 108 108.8 113.5 118Education 4.4 100 137.8 137.8 137.8 137.8 137.7

Hotel & Restaurants 3.5 101.2 102.5 102.5 102.5 118.9 118.9Miscellaneous services 4.2 101.3 103.7 104.2 104.4 110.2 110.5Tobacco 2.5 100 100 100 100 100 100Clothing & feet-wear 7.9 101.2 101.2 101.2 101.2 104.1 104.1Housing, water, electricity & fuels 13.5 100 100 101.4 101.4 103.7 103.7Furniture, domestic equipments & maintenance 4.2 103.1 103.1 103.1 103.1 107.4 107.4Health Care 3.5 100 100 100 100 105.5 105.5Transportation 5.3 100.5 100.5 100.5 100.5 104.9 104.9Communication 3.7 100 100 100 100 104 104Recreation and Culture 3.4 101 103.1 103.1 103.1 104.1 104.1

Source: CAPMAS, February 2008NOTEThe CPI base year is January 2007 and the weights are derived from the 2004/2005Household, Income, Expenditure and Consumption Survey (HIECS) as updated inJan. 2007.

Inflation rate of 9.3% in Sep. 2007 is equivalent to 8.8% according to CPI 1999/2000 base.Inflation rate of 7.5% in Oct. 2007 is equivalent to 7.0% according to CPI 1999/2000 base.Inflation rate of 6.9% in Nov. 2007 is equivalent to 6.1% according to CPI 1999/2000 base.Inflation rate of 6.9% in Dec. 2007 is equivalent to 6.5% according to CPI 1999/2000 base.

Table 2. CPI Inflation, January 2007=100

% Change Jan.-Jan. 2008 Rural Urban OverallAll Item 12.8% 10.5% 11.5%Food & Beverages 18.9% 13.5% 16.2%Source: CAPMAS, February 2008

he accused the official statistics as misleading; the other in the Egyptian newspaperAl-Masry Alyoum, Dr. Nader Fergani, where he accused the government as telling lies.

In fact, the inflation rate as measured by the headline CPI does not concern the poorand low-income people, who are the majority of people in rural and urban Egypt, sincethey spend most of their income on food.6 Indeed, the data on CPI clearly shows higherinflation of food prices. However, the media focus on the 10.5% urban headline inflationrate is inappropriate. Herein lies the problem because it immediately means that themeasure of CPI inflation did not succeed in translating the waves of price rises, whichstrongly hit domestic food markets. In addition, the inflation rate in the price index foreducation services was 37.8% since September 2007, but construction of the CPI basket

assigns a little weight 4.4% on this group for the average consumer. Moreover, there is6Based on the 1999/2000 Household Income Expenditure & Consumption Survey (HIECS) the weight

for food was 38.9% and that for energy, including utilities was 11.7%. In the new CPI series introducedin September 2007, weights have been based on the results of the 2004/2005 HIECS and updated toJanuary 2007, where foods weight was 43.9% and energy, including utilities was 13.5%. Obviously theincreased weight for food from 38.9% to 43.9% in the household consumption is a clear indicator ofincreased poverty. For recent concise discussion on poverty in Egypt see [12]. Detailed discussion andstatistics can be found in two recent studies by the World Bank [ 17] and [18].


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another important point, which is not well understood by the public, the definition of theCPI as prepared by the CAPMAS does not include housing prices (nor prices of any otherfinancial or in kind assets) but rather impute a use-value of flow cost of owner-occupiedhousing service (equivalent rent, or use cost).

3.2. Wholesale Price Index (WPI). The WPI tracked the selling prices of goods thefirst stage of commercialization. These are the prices of goods used locally - whetherlocally manufactured or imported - and the prices of locally manufactured goods - bothfor the domestic market or for export, before they reach the final demand retail stage.

According to CAPMAS, the wholesale price means the price of a commodity beforeany changes are made by wholesale merchants to its shape or nature. The samples weredrawn from the agricultural, mining and manufacturing sectors, and were further classifiedinto groups and sub-groups. Selection was according to their relative importance, basedon domestic production and import. Prices including taxes were collected monthly fromall Egypt.

Table 3. WPI 2005-2006, 1999/2000=100

2006 2007 Sep-SepGroupings Weight Sep Sep Oct Nov Inflation

All ITEMS 100 185.3 204.1 203.9 203.3 10.1%

Farm Products 34.4 216 252.7 247.4 245.6 17.0%Food stuff 18.2 175.8 187.4 192.9 193 6.6%Beverages & Tobacco 2.7 169.1 197.4 197.4 197.4 16.7%Yarn & Textiles 3.9 173.5 174.3 174.3 174.3 0.5%Ready made Garments 1.4 124.5 124.5 124.5 124.5 0.0%Leather& Footwear 0.2 175.7 182.5 182.5 182.5 3.9%Wood & Wooden Products 1.5 190.2 208.9 209 209 9.8%Paper & Printing 1.7 156.3 157.3 159.8 159.8 0.6%Chemicals & Products 7.4 126.7 129.7 132.3 132.3 2.4%

Fuel & related Products 10.5 141.3 142.9 143.8 143.8 1.1%Rubber & Plastic Products 0.6 142.7 146.7 146.7 146.7 2.8%Non metallic mineral products 3.5 147.8 1 46.7 151.3 151.3 -0.7%........ Cement 174.5 170.4 180 180 -2.4%Metals 5.2 277.7 308.3 308.3 308.3 11.0%........ Iron & Steel 286.4 324.4 324.4 324.4 13.27%Metallic prods. Non-metallic & equipment 5.4 169.7 179.5 179.7 179.7 5.8%Transportation Equipment 2.8 176.6 191.3 193.1 193.1 8.3%Other manufacturing products 0.6 217.2 224.3 234.2 242 3.3%

Source: CAPMAS, February 2008

As shown in Table (3), items were classified into 16 main groupings covering aboutone-third of the GDP activities according to the International Standard Industrial Clas-sification (ISIC) Revision 2 (ISIC Rev.2), which was outdated. These main groupingsincluded 67 other subgroups. Additionally, the main groupings were further divided upaccording to (1) the stage of processing, and to (2) the end use. Data were not sea-sonally adjusted. There have been several re-basing and re-weighting used, the latest ofwhich started September 2004, when the WPI data was re-based on weights derived from1999/2000 as a base year. In addition, the weights were also outdated with the turn ofthe millennium. Moreover, importantly, by definition no coverage existed for the serviceactivities of production.


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Figure 1. WPI and CPI in Egypt, 1948-2007

In any case, the WPI series has been discontinued and this price index series is now ahistory. If we look at the historical series of both the WPI and the CPI over half a centuryas drawn in Figure (1), we notice that the WPI and CPI indices tended to vary in tandem


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with each others, and often with lags. We also notice a moderate to low price changes inthe 1948-1974 period, increasing price changes in the 1975-1987 period, decreasing pricechanges in the 1988-2001, and then increasingly to volatile price changes in 2002 -now.The major message from this data is that as long as there was inflation, the WPI washigher than the CPI. Put differently, wholesale prices containing information on the costof production historically transmitted clear signaling information on the CPI inflation ratein subsequent periods. However, it should be borne in mind that wholesale prices havechanged rapidly in recent years because of the cost conditions, but the tendency of theinflation in consumer prices in the subsequent periods did not fully absorb the informationcontained in the WPI. 7 The policy preference not to pass on all the WPI price increasesto the consumer prices is dictated by socio-economic realities. It does however pass it onnot at one shot but rather gradually over time.

4. Price Index Gap in Egypt

In a previous study on the price index for services of production and its importance to

the Egyptian economy,8

a gap in the coverage of price indices in Egypt is recognized asillustrated in Figure (2).

In this figure there are two stages of demand: final demand which is covered bythe CPI including both goods and services, and intermediate demand for transactionsbetween businesses where the wholesale prices used to cover goods only; It was herethat the gap in price indices in Egypt existed; namely, no price indices covered servicestransactions between businesses, whether locally produced or imported service. In thatstudy, two approaches were proposed: (1) discontinuing the WPI series and constructing aPPI series, which covers both goods and services. (2) continuing the WPI series for goodsand constructing a separate corporate service price index (CSPI) for tracking prices ofservice transacted between and among businesses. However, the gap remained intact until2005, when a mission from the International Monetary Fund (IMF) carried out a broad anddetailed assessment framework on economic statistics in Egypt and issued a report thatincluded, inter alia, several recommendations on the price indices regarding data qualityassessment and adherence to standards.9 One of the most important recommendationswas that of releasing a producer price index to replace the old wholesale price index.

In response to the detailed assessment, widespread price series updating has been im-plemented and application of concepts, definitions and methods of processing the basicdata has been adopted. The CAPMAS announced to discontinue the WPI series as of

7Recent advances in time series analysis related to unit root and cointegration make academics and

analysts nervous and debating about spurious correlations. Time-series statistical tools, therefore wouldbe used to study the exact causality link behavior and adjustment to long run relationships. However,despite that hunting for unit root in the price time-series data is tempting, it is evidently well-knownamong academics and price index consultants that the wholesale prices lead consumer prices. As such,whether a unit root exists or does not exist in the price indices data, there is no empirical question aboutspurious correlation and I will not further pursue any hunting for unit roots. Moreover, releasing theWPI series has already discontinued.

8See [11].9See [9].


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Figure 2. Price Index Gap

January 2008, and replaced it by a producer price index series to fills in -at least partially-the price index gap.

5. Producer Price Index (PPI)

Producer Price Index (PPI) series has replaced the WPI series starting January 2008.The PPI tracks the average change over time in the selling prices received by domestic

producers of goods and services for the first commercial transaction. It covers broaderoutput sectors (accounting for 55.5% of the GDP) compared to the former WPI (whichaccounted for 36.1% of the GDP). In particular it covers some services sectors of theeconomy.

The CAPMAS defines the producer prices as those prices paid to the domestic pro-ducers for goods and services on delivery from the location of production. Prices arecollected through a geographically pervasive stratified sample of 1,330 outlets and used


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to construct a family of indices covering 8 groups, 37 sub-groups and 116 economic activ-ities. While the definition implies that prices collected for the PPI purposes record thefirst commercial transaction, say at the farm-gate, wellhead, etc., it does not show clearlywhether the prices take account of discounts and rebates and include taxes and subsidieson products. Accordingly, the definition does not clarify whether the family of indices areinput PPIs or output PPIs.

5.1. PPIs Calculation. At the elementary level which requires no weight, the Jevonsgeometric average of price relatives is used. As shown in section 2 above, the Jevons indexhas desirable properties based on both Theorem 1 and Axiom 1.

Generally, the lack of information on current period quantities prevents statistical agen-cies around the world from producing Paasche or Fisher indices on a timely basis. Thus,at the higher levels, calculating a price index often employs a pure price index based onpricing out a constant basket such as a Laspeyres index. In the case of the PPI in Egypt,the weights are derived from the average values of industrial, agricultural and serviceoutputs of the fiscal years 2002/2003 and 2003/2004 while the selected base-period isthe fiscal year 2004/2005. The index is calculated monthly according to a fixed-weightformula which the CAPMAS calls short-run modified Laspeyres formula, as opposed tothe rules of nomenclature in index number theory. This is given by:

PLSR (p0, pt, q) =

i

st1ipt

pt1

where st1i = s0i

pt1i /p

0i

. From the overview in section 2 in this paper, it is seen that in

making comparison the Laspeyres index uses base-period weights. However, in the caseof PPI in Egypt, the weights s0i are not derived from the selected base-period 2004/2005

but rather from the averages of the two fiscal years prior to it.

5.2. PPIs Classification Structures. There are three main PPI publication struc-tures:

Industry-based PPI. Items are classified into 8 main groups according to ISICRevision 4 as follows: (1) Agriculture , Forestry and Fishing; (2) Mining and Quar-rying; (3) Manufacturing; (4) Electricity , Gas , Steam and Air Conditioning Sup-ply; (5) Water Supply , Sewerage , Waste Management and Remediation Activities;(6) Transportation and Storage; (7) Accommodation and Food Service Activities(8) Information and Communication. These 8 groups include 37 sub-groups and in-dustry price indexes in 116 product sub-sub-groups according to the ISIC Revision4.

Commodity-based PPI in which items are grouped by product similarity of end-useor by processing stage, without regard to the industry in which they were produced.

The product end-use Commodity-based PPI aggregates price indexes orga-nized into 6 groups: (1) Fuels; (2) Crude Materials; (3) Intermediate goods; (4)Consumer Non-durables; (5) Consumer Durables; and (6) Investment Goods.


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The stage-of-processing (SOP) Commodity-based PPI aggregates price in-dexes organized into 5 groups: (1) Fuels; (2) Cotton; (3) Crude Materials; (4)Semi-Finished Manufactured; and (5) Finished Manufactured.

Figure 3. Classification Structure of the Producer Price Index in Egypt

PPI

Commodity-Based Industry-Based

?

??

?

??

Processing Stage Product End-Use

As can be seen from Figure (3), both sets of commodity-based PPIs are drawn fromthe same pool of price information. No classification organizes the non-commodity poolof price information, however. Table (4) shows the recent released industry-based PPIs.The headline PPI y-o-y inflation touched double-digit levels (12.1%) in the Sep-06-Sep-07period. However, only two groups touched double-digit inflation, namely Agriculture,Forestry and Fishing (16.5%) and Mining and Quarrying(25.2%). Manufacturing inter-estingly recorded 4.8%. All remaining 5 groups, which mostly include services, recordedinflation between 0%-3.5%. This puts forward a big question mark.

Table 4. Industry-Based PPI 2007, 2004-2005=100

2006 2007 Sep-SepGroupings Weight Sep Aug Sep Oct Nov Dec InflationAll ITEMS 100 118.7 128.9 133.1 134.7 136.9 137.2 12.1%

A Agriculture, Forestry and Fishing 21.9 137.2 153.7 159.8 156.1 151.5 154.1 16.5%B Mining and Quarrying 21.2 116.8 133.7 1 46.2 1 54.8 1 70.1 1 67.7 25.2%C Manufacturing 42.7 112.1 117.5 117.5 118.6 118.6 119.1 4.8%D Electricity, Gas, Steam and

Air Conditioning Supply 2.6 100 100 100 100 100 100 0.0%E Water Supply, Sewerage,

Waste Mgmt and Remediation 2 128 128 128 128 128 128 0.0%F Transportation and Storage 3 101.7 102.9 102.9 109.7 109.7 109.7 1.2%G Accommodation and

Service Activities 4.8 105.2 108.9 108.9 108.9 108.9 108.9 3.5%H Information and Communication 1.8 107.8 107.8 107.8 107.8 107.8 107.8 0.0%

Source: CAPMAS, February 2008

6. Discussion of Selected Statistical and Economic Issues

In the following, 10 pertinent statistical and economic issues will be cast and discussed.


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6.1. Price Index Gap in Egypt. What first comes to mind is the question: does thePPI bridge the gap in price indices in Egypt? Taking a positive look at the water glass:Yes, to some extent. The PPI covers prices of some locally produced services. However,by definition, the PPI excludes the services imported by producers. (More remarks onservices will be discussed below).

In certain circumstances, neglecting services imported by producers can be justified ifthe value of transactions of local services constitute most of the total value of servicesused by producers and such that imported services (a) do not have any significant effecton the conditions of supply and demand, and (b) do not have any significant effect on thecosts of production of goods and services in the domestic markets. As long as this is notthe case in Egypt, then there is a need for developing price index for imported servicesbase on the available information on the value and share of producers imported servicesin Egypt.

6.2. Construction of the producer price index. The PPI is constructed using weightsderived from the average of 2002/2003 and 2003/2004 values of the total industrial, agri-

cultural and service sectors outputs, and the base year is 2004/2005.

It is well-known that the period 2002-2005 was characterized by high inflation andthe macroeconomic instability due to excessive volatility in the exchange rate, especiallythe significant successive reductions that occurred during the period 2002 - 2004 andup to the full liberalization and unification of the exchange rate markets by the end ofDecember 2004, followed by unprecedented rises in the foreign exchange rate during thefirst few months of calendar year 2005, which correspond to the other half of the fiscalyear 2004/2005, the year which is taken as a base year for the index.10

Based on both the statistical and economic convention, taking a period of instability asa source for deriving the weights or as for selecting a base is incorrect. It is therefore pro-

posed to use the fiscal year 2005/2006 to derive the weights, and the fiscal year 2006/2007as a base period. Moreover, if the CAPMAS could update the CPI base period, whichis currently the month of January 2007, there will be a common relevant base-period forcontrasting the major price index statistics in Egypt.

6.3. Surveyed Industrial, Commercial and Service Enterprises. The coverage ofprices collected for constructing indices to all sizes of enterprises (whether the size clas-sification is based on the volume of capital, business turnover, number of workers) isnot known. Typically, the average (fixed and variable) cost structure significantly variesdepending on the size of the enterprize: large enterprises, medium-sized or small-sized.

Limiting the coverage to large enterprises may bias the index.10The transition to the unified exchange rate regime was completed in December 2004 and the foreign

currency surrender requirement, which required companies to exchange their foreign currency revenues atpublic sector banks at some administered exchange rate, was abolished at the same time. Shortly later,Egypt has notified the International Monetary Fund (IMF) that it has accepted the obligations of ArticleVIII, Section 2, 3, and 4 of the IMF Articles of Agreement, with effect from January 2, 2005. Over theperiod January-July 2005, which is the second half of the fiscal year 2004/2005 the dollar exchange ratespiked to its historical unprecedented level of over EGP 7.


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There are indications that suggest that the market structure is developing and ex-panding to favor the activities of small and medium-sized enterprises. For example, theMinistry of Investment in the framework of developing the capital market and financialsector established a market for small and medium-sized enterprises in the Egyptian StockExchange.

6.4. Treatment of Exports and Imports. There is no explanation about the treat-ment of exports and imports within the PPI in Egypt. It is presumed, however, that ifthe point of sale for Egyptian exports is Egypt, then the prices of these exports shouldenter the producer price pool for indices.

On the other hand, it is not clear how imports where the point of sale is in Egypt (e.g.from free and investment zones), are dealt with. Overall, such imports are directly relatedto the cost of domestic production and it is assumed that any such imports should enterthe PPI price pool for indices. Indeed, it is not uncommon for business partners to importproducts and equipment for their own use in the free zone, but find their way into thecountry, which is legally considered external jurisdiction, and thus the observed selling

price may include the import duty payable on the value.

6.5. New Goods & Services and Changes in Quality. As technology advances,new goods and services appear and over time may replace old ones. Examples includethe expansion of the use of natural gas in many production processes including its use asvehicle fuel in the transportation energy mix, and the expansion of Voice over InternetProtocol (VoIP) with virtual private Network (VPN) services in multi-branch businesses,which gradually replaces fixed telephone lines. Critical statistical issues are also raised bythe technological advances that change the quality characteristics of goods and services.Of course, the more the quality characteristics, the higher the price. The CAPMAStreats new products and quality based on matched-models, which -according to the IMF

Producer Price Index Manual- are considered second-best methods and may fail on severalgrounds. Many statistical agencies in the world, however, apply hedonic methods ineconometrics such as the following log-linear form 11

lnpit = +n

j=1

j ln xijt +Tt=0

tDikt + uit

where xijt, represents a j-th characteristic of the i-th good or service at period t, Dikt rep-resent k-period dummy variables and uit random error term. Holding quantity constant,this decomposes the changes in price to pure price change and pure quality change. Theindex is calculated by exponentiating the estimated time coefficients on Dikt, with index

for t = 0 interpreted as the base period for the price index. Most empirical studies foundthat the quality-adjusted price indices are lower than the standard price index due to thehigher quality characteristics of goods and services available in the markets. In the caseof the markets and prices covered by the PPI in Egypt, the situation is more puzzlingwhere the markets are dumped by (1) Chinese cheap products, (2) products of qualitybelow both Egyptian and international standard specifications, especially spare parts and

11see [14] and [15].


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maintenance materials, and (3) products of unknown origin and whose characteristics arehidden. Solving this puzzle truly requires that the CAPMAS adopts a hedonic elementaryprice index methodology.

6.6. E-commerce Revolution, and Globalization. The e-commerce revolution and

globalization have undoubtedly great effect on business and industrial community and thedigital economy in Egypt. In 2004, the Law No. 15/2004 organizing Electronic Signaturehas been passed and made effective signing electronic documents and contracts the sameas legal and authentic as signing physical documents and contracts.

With the proliferation of the information and communication technologies since theturn of the new millennium, outsourcing of managed services in the production of goodsand services in Egypt on the basis of contracting in the cyberspace has tremendouslyincreased. It is evident that outsourcing has become an integral part of B2B transactions,for example in call centers, e-payments and credit card processing, auditing, productdesign, modelling and other business services of high intellectual property rights content.

Some companies formed business partnerships and alliances especially with domestic andforeign affiliates existing in other countries. 12

The collection and measurement of statistical data on the prices of such ever-growingactivities of the digital economy in Egypt seem absent in the construction of the PPI.Therefore, the survey system of the PPI should be extended and strengthened to ensureproper coverage and to deal with the practical aspects. To begin with, we propose that fu-ture CAPMAS questionnaire surveys on establishments and enterprises include questionson transactions and expenditure via electronic commerce and Internet services.

6.7. Measuring Prices of Service and Coverage. While the share of the services has

been increasing in gross national product over time, the problems of collecting price datafor the services, measuring service units, and covering the wide array of services remain.

In the current PPI, no classification is derived from the non-commodity pool of producerprice indices and the included prices of services are NOT classified according to whetherthe prices are for domestic services, or for exports.

Additionally, the current PPI coverage of services is quite limited. It does not coverthe prices of financial banking services and financial non-banking services, such as in-surance and reinsurance. It does not cover the prices and fees charged by mutual fundsmanagement services, the securities and exchange services, real estate finance services,construction services, rental of machinery and equipment services, maintenance services,

printing, advertising and other production services.

12The trend in e-commerce and globalization is motivating establishing a full-fledged statistical systemfor services on both the national and international levels. Currently there is already an interagencytask force working on updating the IMF Manual on Statistics of International Trade in Services bythe end of 2008 to be adopted by the United Nations Statistics Division (UNSD) and published in2009. See [16]. The most recent update on the progress the Task Force should be available online at:http://unstats.un.org/unsd/tradeserv/TFSITS/default.htm
http://unstats.un.org/unsd/tradeserv/TFSITS/default.htm


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6.8. The Failure of Market Controls and Poor Oversight. The actual policiesapplied by the government under the economic reform and structural adjustment packageagreed upon with the international institutions include the liberalization of prices of goodsand services such as energy prices (natural gas, gasoline, diesel, and other petroleumproducts) and electricity tariffs, inter alia, controlled by the government and the publicsector. The price increases by the government lead ahead, and then followed by producersraising the prices of services such as freight and storage and the prices of goods such asconstruction materials due to higher costs of production.

There are already technical production coefficients, and on the basis of which a knownrange for the increase in costs resulting from changed prices of inputs can be calculated.For example, if natural gas accounts for 40% of the cost of cement production, and theprice of natural gas increased by 50%, this means that the increased cost (and producerprice) of cement will be 20%.

However, the current problem is that companies raise prices of goods and serviceswithout controls because of the absence of Governments agreement with the private sector- through negotiation - prior to its decision to raise prices or reduce subsidies. Even whenthe government reached freely negotiated price agreement with companies in the privatesector, as in the case of the agreement concluded with the cement producers to stabilize theprice of cement at about EGP 300 per tonne on-the-factory-gate in September 2006,companies deviated and substantially increased their prices. Weak regulatory and lawenforcement framework and poor effective oversight on the markets resulted in recursivespirals in producer prices taking place in the markets over time. The question arises hereas to what price CAPMAS observes and collects? Does it collect price as is or as itshould be because the government had not approved an increase, abstracting from theprice prevalent in the market?

6.9. Cost Escalation and contracts. Cost escalation clause refers mainly to contractvalues and price differentials in the implementation of a contract as it is periodically,whennecessary, reviewed; the Ministry of Finance has recently directed to this escalation inthe amendment of Tenders law No. 89 in 1998. Escalation achieves financial balance incontracts, and applies when the consequent delays in the implementation of some projectsincrease contractors burdens, and in the case of prices increases and volatility in exchangerate. Article 22 bis of Law No. 5 in 2005, amending some provisions of the Tenders Lawpromulgates compensation if the contracting party failed to implement their obligationswith contractors by delaying payment in the equivalent to the cost of funds in accordancewith the lending and discount rate announced by the Central Bank.

Most of the projects include significant civil engineering component, e.g. educationalbuildings, sewage networks, water systems or water pipeline networks, etc. and belong tothe Ministry of Housing. Article 22 bis (1) of Law No. 5 in 2005, stipulates the following:

In the contracts to be implemented in a period of more than a year, thecontracting party commits to escalate the value of the contract at the end ofeach year in accordance with the increase or decrease in costs that have takenplace in terms of the contract after the date set for opening technical offers


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or after the date of contracting based on direct procurement, in accordancewith parameters specified by the contractor in the tender and upon whichthe contract is based; this escalation shall be binding to the parties.

The Egyptian Federation of Construction and Building Contractors recently called foramending Law 5 in 2005 so as to escalate the difference in prices quarterly instead of

annually to take into account the cost of the project given the soaring inflation in theprices of all construction materials,including not only iron, cement, but also wood, paints,and others. Engineer Ahmed El-Maghraby, Minister of Housing, was more generous; Heannounced plans to escalate new contracts for the difference in the prices of buildingmaterials every two months, given rapidly soaring prices. In many countries, however,the producer price indices meet the purpose of contract escalation,which gives a unifyingframework for the base of calculations, rather than leaving it to the generosity or courtesiesof ministers.

Overall, the producer price indices currently seem not yet ready to provide guidancefor contracts. Moreover, at the operational level in tender bidding and practices, no rules

define whether to take the headline index or sectoral more specialized index. This isan important issue because taking the headline or sectoral index implies tens and evenhundreds of millions of cost expenses.

6.10. Inflation Targeting. Observed monetary policy formulation recently indicatedthat moving from monetary (money and credit) aggregates targeting towards inflationtargeting (IT) is formally on the agenda of the Monetary Policy Committee (MPC) of theCentral Bank of Egypt (CBE).13 It is evident in IT that producer prices are not target;taking the increase in the PPI as target in combating inflation is out of question, notonly in Egypt but - to the best of my knowledge - in any other country because producerprices do not measure the daily cost of living of the people.

While monetary policy appears more responsive to inflationary pressures recently, at-tention must be paid to the targeted inflation rate in Egypt. IT is a monetary policyrule regarding inflation expectations with the objective of maintaining inflation rate at aconstant level or within a certain band. But which inflation? headline inflation rate ofthe CPI in urban areas, or in all Egypt? inflation of the CPI in partially disaggregatedgroup, e.g. Food and Beverages? Additionally, no explicit target for inflation has everbeen declared by the CBE nor it compiles a Core Inflation measure, which is a conceptadopted by monetary authorities in many countries in the world. 14

13On February 1, 2007, the MPC decided to maintain the overnight lending and deposit rates at 8.75%

and 10.75%, respectively, despite wide expectations of rising inflation. One year later, on February 7,2008, the MPC decided to increase these rates by 0.25%. Another increase by 0.5% was decided onMarch 25, 2008 and the rates currently stand at 9.5% and 11.5%, respectively. The decisions were basedon Elevated international food prices have led to the acceleration in domestic food inflation, which inturn have been propagated on non-food inflation. Moreover, the MPC statement reflected monetarypolicys concern over the evolution of asset prices by referring to the higher economic growth rates inmanufacturing and construction that may precipitate more inflationary pressures. See [ 4]. However,it is well-known that the CPI in Egypt does not track or account for any asset prices.

14See [2] and [13] for general and detailed discussion of conceptual issues and [ 1].


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As a result, there are mounting concerns about (1) what price index is targeted forinflation, and (2) how expected rate of change in price levels is determined. While thereare still critical statistical issues regarding the CAPMAS off-the-shelf CPI inflation rate,when the PPI is well-developed and proved reliable, it can contribute to the informationrequirements for measuring the expected rate of inflation in the CPI. Indeed, a well-developed PPI that accurately and reliably measures the prices at the source beforeadding the values of the margins of commerce, transportation and discounts etc. whichsignificantly vary between products and between regions, will indicate the inflationarytrends at the retail stage. For example, today, all people talk about wheat cultivation,wheat trade, wheat supply and wheat procurement at any cost. As wheat futures pricesreached unprecedented levels, it is expected that large unprecedented increases in theprice of wheat will not translate immediately in the consumer price of subsidized bread,but ultimately will find their way to the prices of other bakery products, and to the pricesof macaroni, pasta, flour, starch and other foods at grocery stores. That will also pushhigh the prices of substitutes such as rice, which will exacerbate food price inflation.

7. Conclusion

So, what are the implications of the producer price indices for policymaking and man-agement in Egypt? The economic reform and structural adjustment package Egypt hasbeen implementing in agreement with the international institutions includes, inter aliaderegulation of prices, reductions of subsidies and the removal of protection for domesticproduction of goods and services. It is known under such package that conditions mayworsen before getting improved; actions to increase growth rates, increase employmentand reduce unemployment, are usually accompanied by a rise in inflation rates.

Certainly, the quality of price indices has improved. Despite the fact that there areencumbering problems, the introduction of a PPI series in Egypt is a good starting point.It will require further development to qualify as an effective reference tool in policymakingand implementing projects of development. In particular the potential for PPI to palya major role in: (1) contact escalation for projects with duration that extends over ayear, so as to ensure the sound calculation of the costs, and achieve financial balancingin bidding and contracting; (2) classifying service prices according to whether they aredomestic prices, or for exports, so as to highlight Egypts competitiveness in the emergingservice sectors. (3) providing a reliable means of measuring and monitoring inflation incommercial transactions between and among businesses, especially in the services markets;and (4) signaling information which provides early warning about future CPI inflationary

pressures that may be in the pipeline, provided that temporary effects on the costs areexcluded.

Finally, I call upon the publishing of all the facts, descriptions, methods and the baseson which price data is collected and coded. Making available to the community all thedetails transparently will build more confidence and prevent disregarding recklessly theofficial statistics. When I studied game theory, I realized the importance of the CommonKnowledge rule assumed about the structure of the game: You know it. You know I


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know it. You know I know that you know it etc. In such games, the player does not lieor cosmeticize.

REFERENCES1. Al-Shawarby, Sherine (2007) Inflation Measurement in Egypt: Assessment of CPI Accu-

racy, Proceedings of the conference on What Drives Prices in Egypt? organized by theEgyptian Center for Economic Studies (ECES), Cairo, November 25-26.

2. Carlstroma, Charles T. Fuersta, Timothy S. and Ghironic, Fabio (2006) Does it matter (forequilibrium determinacy) what price index the central bank targets?, Journal of EconomicTheory Volume 128, Issue 1, May 2006, Pages 214-231.

3. CAPMAS (2008) Monthly Price Index Bulletin, available at msrintranet CAPMAS Web-site

4. Central Bank of Egypt (2008) MPC Press Release on February 7, 2008 , available onlineat http://www.cbe.org.eg/public/Press Release February 7, 2008E.pdf

5. Diewert, Erwin(2005) Some Issues Concerning Index Number Theory, Paper presented atthe ESRI Conference on the Next Steps for the Japanese System of National Accounts:Towards More Accurate Measurement and More Comprehensive Accounts, held in Tokyo,March 24-25, 2005.

6. Fisher, Irving (1922) The Making of Index Numbers,Boston, Houghton Mifflin

7. Huff, Darrell (1993) How to Lie With Statistics, W. W. Norton & Company, ISBN-10:0393310728 ISBN-13: 978-0393310726

8. International Monetary Fund (2004) Producer Price Index Manual, Theory and Practice,Chapter 15, IMF Washington DC, August, ISBN 92-2-113699-X.

9. International Monetary Fund (2005) Arab Republic of Egypt: Report on the Observance of

Standards and Codes Data Module, Response by the Authorities, and Detailed AssessmentsUsing the Data Quality Assessment Framework, Washington DC, IMF Country ReportNo. 05/238, July 2005

10. International Monetary Fund (2007) International Financial Statistics, online and CD-ROM databases.

11. Nawar, Abdel-Hameed H. (1993) The Production Services Price Index: Assessing the Im-portance of its Measurement to the Egyptian Economy, Researcher #5, CEFRS, Facultyof Economics and Political Science, Cairo University, Egypt, in Arabic

12. Nawar, Abdel-Hameed (2007)From Marina to Kom-Ombo: A Note on Poverty in Egypt,Cairo University, manuscript August

13. Rich, Robert and Steindel, Charles (2005) A Review of Core Inflation and an Evaluationof Its Measures, Federal Reserve Bank of New York Staff Reports 236 December

14. Shiratsuka, S. (1995a) Effects of Quality Changes on the Price Index: A Hedonic Approachto the Estimation of a Quality Adjusted Price Index for Personal Computers in Japan,Monetary and Economic Studies, Bank of Japan, Vol. 13:1, pp.17- 52.

15. Shiratsuka, S. (1995b) Automobile Prices and Quality Changes: A Hedonic Price Analysisof the Japanese Automobile Market, Monetary and Economic Studies, Bank of Japan, Vol.13:2,pp. 1-44.
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16. United Nations Statistics Division (2002) Manual on Statistics of International Trade inServices, Department of Economic and Social Affairs, Statistics Division Statistical PapersSeries M NO. 86, New York

17. World Bank (2005)Egypt - Toward A More Effective Social Policy: Subsidies and SocialSafety net, Social and Economic Development Group Middle East and North Africa Region,The World Bank, December 16, 2005, Report No. 33550-EG.

18. World Bank (2007) Arab Republic of Egypt A Poverty Assessment Update, Volume I: MainReport, June 17, 2007

ppi and measuring inflation in business transactions

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