China now the world’s largest economy?

October 23, 2014 by Brendan O'Reilly

For more than a century America’s economy has been the largest in the world, but is that all about to change? Earlier this month the IMF reported that the size of America’s economy had been surpassed by China, when measured in terms of purchasing power parity (PPP). But what does this mean? In economics, nothing is as simple as it seems.

First of all, let’s be clear on what we are talking about. The IMF was very specific in referring to a comparison based on purchasing power parity (PPP). This measure accounts for the cheaper cost of most goods and services in China. To calculate the difference in purchasing power, the IMF looks at the price of a “basket” of several thousand goods and services. The theory assumes that it would cost exactly the same number of, say, US dollars to buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use those dollars directly in purchasing the market basket of goods.

However, as Shen Jiru, of the Chinese Academy of Social Sciences, told the People’s Daily: “When using PPP, it is impossible to compare all the merchandise in both countries; only a group of items can be used. The US and China have great differences in price structure. Some things are very cheap in China, like dental care costs for instance, while some are extremely expensive, like houses and cars. It is quite possible to exaggerate China’s economy by using PPP.”

Professor Yao Shujie from the University of Nottingham in England also has reservations with the PPP measurement, while crediting the IMF’s assessment of the strong international trade and sheer size of China’s physical economy: “In nominal terms, in 2013 China’s GDP was about 55% of that of the US. However, if one uses PPP exchange rate instead of the official nominal rate, it is highly possible that the absolute size of China’s economy may well have overtaken the US.

“The reason the IMF states that China has become the world’s number one economy could be justified in the following way: a) on average, using the consumer baskets in both countries, goods and services in China are much cheaper than in the US; b) China’s value-added in the manufacturing sector is about 20% higher than that of the US; c) Exports and the total trade volume – including imports and exports of goods – greater for China than the US; d) China produces far more key agricultural and industrial products than the US – for example, China’s steel output is about 10 times that of the US. It also produces larger amounts of other products such as grains, fruits, vegetables, fish, coal, clothes, computers, TV sets and motor vehicles, etc, than the US.”

A huge part of the popular legitimacy of the ruling Communist Party rests on its recent success in raising the living standard of the population. Chinese officials have a strong interest in inflating their economic figures. ‘Prosperity and power’ 富强  form the central foundation of the “Chinese Dream” promoted by President Xi Jinping since he assumed overall leadership two years ago.

As the People’s Daily is only to willing to point out: “A mere 30 years has let 660m people rapidly escape poverty”. And party officials know only to well that their prospects for advancement, even their very existence, are tied to the economic development of the areas they govern.

Xie Yaxuan, an analyst at China Merchant Securities, says the myopic focus on economic growth has exacerbated problems in many areas: “Using GDP as the main assessment method has caused a lot of problems, like unequal income distribution, problems with the social welfare system and environmental costs.”

With growing public and official awareness of the costs of blindly pursuing economic growth, recently there has been a shift in the rhetoric and focus of the Chinese government. Some regions have scrapped GDP-based assessments for the performance of local officials, while the central government is trying focus on the “quality and sustainability of economic and social development” instead of looking only at the raw numbers.

Even the People’s Daily has declined to gloat over the past growth of the Chinese economy: “The big, bold headline “China becomes the world’s largest economy” does not describe the reality. More importantly, decision-makers in China need to keep a cool head and realize that size is not everything when it comes to the economy; quality and efficiency are more important.”

At the same time, China’s rapid economic development and expansion is undeniable, despite lingering doubts and concerns. From the late 1970s until early this decade, China averaged 9.9% growth in GDP per year. Meanwhile, the population increased by roughly 40% during the same period. GDP per capita increased by over twenty-fold during a single generation. However, while extreme poverty has been greatly alleviated, the fruits of China’s economic miracle have not been evenly distributed.

And once again, it is the People’s Daily that attempts to bring a touch of reality to the figures: “Just as Chinese vice-minister of finance Zhu Guangyao said at a recent forum, if calculated on actual market exchange rate, not PPP, China’s estimated GDP for 2014 would be $10.4tr, far less than that of the US. Currently, the GDP of the US is $16.8tr, while China’s is about $9.2tr, despite the fact that China’s population is more than four times bigger.”

The article goes on to point out that by 2019 the IMF’s forecast for US GDP shows the latter’s economy will be nearly 60% greater than China’s – $23.4tr versus an estimate of $14.8tr for China – and notes that Kaushik Basu, chief economist of the World Bank, has also said that the US remains the biggest economy when considering the exchange rate of the yuan and the US dollar, and it would take a long time for China to surpass it.

Perry Jones, chief analyst at the Kearsedge Boston Group, credits practical government policies enacted in the 1980s with spurring China’s rapid economic development: “By freeing up rural residents to grow food and produce and then profit by selling that food on an open market, China’s leadership observed that this produced a rapid rise in living standards in the region. The government realized that this phenomenon could be extended throughout the economy. Citizens were allowed to profit from their own labour and businessmen were permitted to profit from their own capitalist undertakings.”

However, Jones also worries that structural changes, demographic trends, and related government policies may slow the Chinese economy: “Most of China’s young adults are already at work in China’s densely populated urban areas in factories and offices. Rural areas remain – for the large part – the domain of the elderly. Although the leadership has recently relaxed the one-child policy, it has not come soon enough to affect the eventual decay in the labour class who will have to support the increasing numbers of the elderly.

“Economically”, he adds, “investment has been far too focused in state enterprises, real estate, corporate bonds and municipal debt. China’s economy is maturing. As China enters the next phase of economic development in its growth cycle, the focus will naturally shift from the industrial sector to a more service sector orientation. Services represent a ‘softer’ footprint and thus less economic growth can be released from a service oriented economy.”

Indeed, the signs are everywhere that China will not be able to continue its rapid economic growth. After decades of near-double-digit growth, the Chinese government is setting its economic sights lower, with this year’s target being a (still quite robust) rate of 7.5%. The Chinese economy cannot rely solely on low-wage, labour-intensive exports, as economic development and labour shortages are already leading to rapidly rising wages.

Many low-skilled industries are leaving China for countries with lower labour costs, such as Cambodia and Vietnam. The cooling of China’s domestic housing market has also highlighted fears of a possible credit crisis within the country, as much of the post-2008 growth was built on large levels of debt.

While China’s overall economy has developed rapidly, there are still hundreds of millions of Chinese living as subsistence farmers in isolated rural areas. Their relative poverty still represents a huge potential for China’s economic growth. According to official statistics, per capita GDP in Guizhou, China’s poorest province, is $3,701 – only a third of the average GDP in Jiangsu, the richest province (although incomes in directly-administered urban areas, such as Beijing and Shanghai, are even higher). If all of China were as developed as the relatively prosperous coastal provinces, then China would already have the world’s largest economy in nominal terms.

Regardless of the current challenges, many experts believe China could overtake the US as the world’s largest economy in nominal terms sometime in the 2020s. Assuming a 7% growth rate in China’s GDP, and a 2.25% rate in the US (with factors such as renminbi appreciation and inflation holding fairly stable), China could, according to The Economist, have the world’s largest GDP by 2021.

Professor Yao Shujie is cautiously optimistic about the potential for China’s economic growth: “It will be quite challenging for China to maintain 7% plus annual growth, but it has a good potential to do so in the next 5 to 10 years. If so, China will overtake the US in nominal terms before 2025.”

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