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Military spending as percentage of GDP is the most used measure of the economic capability of a certain country/military. But Some countries like India for example, have a huge difference between their nominal and PPP GDP (2 billion vs 7.7 billion). So which number is more meaningful to express the economic capability of a certain military ?

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One argument for using the exchange rate:

Market exchange rates are determined by the supply and demand of currencies used in international transactions. However, the prices of many goods and services on domestic markets are determined in partial or complete isolation from the rest of the world. Therefore, the MERs do not always accurately reflect differences in price levels between countries.

An alternative is to use purchasing power parity (PPP) conversion factors (or PPP exchange rates). The PPP dollar rate of a country's currency is defined by the World Bank as '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'. >1 The only PPP rates available for all countries are GDP- based basket of goods and services that are major components of the gross domestic product. Such GDP-based PPP rates are designed to control for differences in price levels and thus to provide a measure of the real purchasing power of the GDP of each country.

Using GDP-based PPP rates instead of MERs for currency conversion results in much higher output and expenditure figures for many developing and transition countries since they have relatively low prices for non-traded goods and services—thus giving the currency higher purchasing power. A unit of local currency therefore has greater purchasing power within a developing country (which is better reflected by using PPP rates) than it has internationally (which is what is reflected by using MERs). For those such developing and transition countries for whom data was available for 2008, the median increase in military expenditure figures from using PPP rates instead of MERs was around a factor of 2. Three-quarters of these countries would see their relative figures increase by at least two-thirds. Meanwhile, using PPP rates would cause the GDP and military expenditure figures of most 'developed' countries to fall relative to the USA, by a median rate of 17 per cent—reflecting the low value of the US dollar at market exchange rates in 2008. However, the reliability of such PPP rates is lower than for MERs, since PPP rates are statistical estimates, calculated on the basis of collected price data for a basket of goods and services for benchmark years. Between benchmark years, the PPP rates are extrapolated forward using ratios of prices indexes, either GDP deflators or consumer price indexes. Like all statistical estimates they are subject to a margin of error.

Furthermore, GDP-based PPP rates are of limited relevance for the conversion of military expenditure data into US dollars. Such PPP rates are designed to reflect the purchasing power for goods and services that are representative of spending patterns in each country, that is, primarily for civilian goods and services. Military expenditure is used to purchase a number of goods and services which are not typical of national consumption patterns. For example, the price of conscripts can be assumed to be lower than the price of a typical basket of goods and services, while the prices of advanced weapon systems and of their maintenance and repair services can be assumed to be much higher. The extent to which this data reflects the amount of military goods and services that the military budget can buy is not known. Due to these uncertainties, SIPRI uses market exchange rates to convert military expenditure data into US dollars, despite their limitations.

Stockholm International Peace Research Institute: Monitoring Military Expenditures

But wages are a big part of military costs and those are not paid with PPP GDP but rather domestic GDP. MEASURING HARD POWER: CHINA’S ECONOMIC GROWTH AND MILITARY CAPACITY says that both methods have merits but at least in China, both methods understate military capacity.

The most appropriate way to compare real military capacity across countries is to deflate each country’s actual, or potential, military spending by the price of real military services in each country. Unfortunately military price indices do not exist for most countries. The aim of this paper, therefore, is to develop a simple method for computing a relative military price index, that deflates nominal spending into units of real military services, using readily accessible data. The ratio of two countries’ military price indices then gives an exchange rate that provides an index of relative real military capacity across countries. We use this military exchange rate to compare the level and growth of China’s real military capacity relative to the USA. 4 We obtain two key results. First we find that the value of the RMB, in terms of its ability to purchase real military services, is greater than both its market exchange rate value and its PPP value. This suggests that conventional estimates of GDP understate China’s real military capacity, but also that PPP exchange rate comparisons are much closer to the actual value than market exchange rate comparisons. This is mainly because of the very low cost of labor in China relative to the USA. ...

If we wish to infer country’s miliary capacity based on the size of its economy, however, standard PPP indices also pose a problem insofar as they reflect the relative price of an average basket of goods produced in the economy and this average price index may differ substantially from the price of military services. Thus Crane et al (2005) argue that, while military services have large personnel costs, a substantial share of military equipment purchased by developing-country militaries is imported or incorporates com- ponents that are manufactured from materials and parts sold at world market prices, such as electronics, diesel engines, or aircraft frames. Thus they suggest that, for some purposes, GDP measured at market exchange rates may give a more realistic picture of changes in military capacity (Crane et al 2005, pp.16-17). Similarly, the two principle military statistical abstracts, The Military Balance published by The International Institute for Strategic Studies (IISS), and the Stockholm Interna- tional Peace Research Institute’s (SIPRI) Yearbook report relative military spending and relative GDP in terms of $US converted at market exchange rates and also at PPP ex- change rates. IISS (2012) notes that market exchange rates are likely to understate the true level of economic resources allocated towards defence since food material and hous- ing costs will be lower in China, but remain noncommittal in recommending a preferred price index. 8 Thus they often report a weighted average of PPP and market exchange rates when discussing China’s real military capacity relative to the USA.

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