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Mobility Basics - Why do cost of living indices change?

Cost of living indices show the difference in day-to-day living costs between an international assignee’s home and host location. They are frequently used as part of the home-based approach to calculate expatriate pay, where the intention is to ensure that the assignee is no better or worse-off on assignment than they would have been had they stayed at home.

When cost of living indices are updated to reflect changes in living costs in the two locations, assignees often question why certain indices have changed in the way that they have. 

There are two factors which lead to changes in the cost of living index: changes in the exchange rate between the currencies of the relevant countries and price changes in the home and host location.

Exchange rate movements

The cost of living index is always linked to a specific exchange rate and can be adjusted for a different rate using a simple formula. 

When the exchange rates are compared, if the home currency has lost value compared to the host currency, the index will increase as more home country currency will be needed to maintain the same standard of living in the host location. 

If the home currency has lost value compared to the host currency, the index will increase

If the home currency has strengthened against the host currency, the index will decrease as more host country currency can now be purchased with the same amount of home country currency.

If the home currency has strengthened against the host currency, the index will decrease.

Example

When we conducted a cost of living survey in March 2016, the exchange rate between the UK and Germany was GBP 1 = EUR 1.283. By the time of our latest survey in September, the shock of the Brexit vote had caused an already weakening sterling to devalue to the point where GBP 1 = EUR 1.172.

Updating the March 2016 UK – Germany index for the new exchange rate gives the following:

Original index    115.8 @ GBP 1 = EUR 1.283
New exchange rate GBP 1 = EUR 1.172
New index = original index x original exchange rate / new exchange rate
  = 115.8 x 1.283 / 1.172 
  = 126.8

So, ignoring any changes in prices in the two locations, the devaluation of the pound has caused the cost of living index for UK employees on assignment in Germany to increase.

Changes in prices

ECA calculates cost of living indices based on a comparison of prices collected for a basket of specific goods and services in the home and host locations. 

If prices in the host location increase more on average than for the same items in the home location, the index will increase.

If the pricesin the host location increase more than in the home location the index will increase.

If prices in the host location increase less on average than for the same items in the home location, the index will decrease.

If the prices in the host location increase less than in the home location, the index will decrease.

Example

In March 2016, the index for someone from Windhoek, Namibia working in Johannesburg, South Africa was 128.1. Since then, prices in Windhoek and Johannesburg have increased by 7.3% and 7.1% respectively, according to ECA’s survey.

Updating the March 2016 Windhoek - Johannesburg index for these price changes gives the following:

Original index 128.1
Host price change +7.1%
Home price change +7.3%
New index = old index x host price changes / home price changes
  = 128.1 x 1.071/ 1.073
  = 127.9

There has been no movement in exchange rates between these two countries, so the index has decreased slightly because prices in the home location have increased more than than in the host, narrowing the differential between the two. As this expat will have seen prices increasing in Johannesburg but is unlikely to be familiar with how prices are changing at home, they might have been expecting an increase in their COLA rather than a decrease.

Exchange rate movements can exacerbate or cancel out the effect of price changes. A Brazilian working in Argentina, for example, who has seen prices there rise by 36% in the last 12 months, may be surprised to learn that their index has gone down by nearly 30% in the same period. This is because the increase in host country prices has been mitigated to some extent by an 8% increase in prices back home and, more significantly, the Argentinian currency has devalued by 44% in comparison to that of Brazil:

Index movements

ECA’s Cost of Living Calculator includes clear explanations of the degree to which index movements have been determined by changes in prices and exchange rates, as shown above, for every location in your subscription.

ECA can support you and your team with advice on cost of living, price changes and exchange rate management. Your account manager will be more than happy to help you with explaining any index movements, so do get in touch!

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