China won’t pass the U.S. anytime soon

There has been a lot of commentary recently on the International Monetary Fund’s (IMF) projection of China’s GDP passing that of the United States to become the world’s largest by 2016. That only proves the adage that "there are lies, damn lies, and statistics."

The IMF number that has gotten such attention is the Chinese GDP as calculated based on purchasing power parity (PPP) numbers. If this sounds like gobbledygook, it kind of is. On the one hand, it is a useful calculation to make certain international comparisons with regard to standards of living. So for example, if you make only $2000 annually but your food costs only $200, you may be better off than someone in another country who makes $20,000 annually but who has to pay $10,000 for food. Or maybe the food comparison is not apt because diets differ between countries. In the Americas, potatoes tend to be inexpensive and serve as a main form of starch in the average diet. In Asia, potatoes tend to be expensive. So if you compare how many potatoes one can buy with a certain income in the Americas to how many one can buy with the same income in Asia, the Asians will appear to be poorer and to have a lower standard of living than the Americans. But Asians don’t eat potatoes as their main form of starch. They eat rice, and rice in Asia tends to be inexpensive. So a better standard of living comparison is between how much rice an Asian can buy with a certain income as against how many potatoes an American can by with the same income.

So far so good. In this way, the PPP calculation gives us a better understanding of the real purchasing power of incomes in various societies. The most famous PPP calculation is the Economist‘s Big Mac index. This is the comparison of how much it costs in various countries to buy a Big Mac from McDonalds. Since Big Macs have become a kind of shared international good, the index is a fairly accurate way of measuring comparative standards of living around the world.

But, the PPP calculation has a serious limitation. It does not at all reflect international buying power and thus is not at all an accurate measure of relative global economic and geo-political power. International transactions are done at nominal, not PPP, currency values. For example, you might be able to buy a night at a hotel in Washington D.C. for $300. If you go to Paris, you don’t buy a hotel room with PPP dollars. Rather you have to exchange dollars for euros at the nominal exchange rate and then pay for the room in euros. At current rates, the same room in Paris is likely to cost you about $500. So while in PPP calculations you may be said to have the same hotel room in Washington with your American income as a Parisian has in Paris with his/her higher European income, when you go to Paris, you will, in fact, be poor in comparison to your French friends.

Let’s get back to China: On a PPP basis, the IMF says that China’s current GDP is about $11.5 trillion while that of the United States is $15.2 trillion. But at current exchange rates, the IMF notes that China’s GDP is only $6.5 trillion or a little more than a third the size of the U.S. GDP. That is the more important figure to look at when considering relative international buying power and economic and geo-political influence. The IMF has China passing the U.S. GDP in 2016 on PPP calculations. But on a real exchange rate basis, the IMF numbers show China’s 2016 GDP to be only about two thirds that of the United States.

Now, let’s add another dash of reality. Those numbers all assume that China’s growth rate continues to rise in pretty much a straight line. But maybe it won’t. Here are two things to keep in mind. One is that the Chinese population will begin to age rapidly in the next few years and that is likely to have some slowing effect on the GDP. In addition, we must understand that China’s growth is extremely investment intensive. Domestic consumption accounts for only about 35-40 percent of GDP.

In recent years, China has been in the situation that it gets less GDP growth-per-dollar or yuan invested each year. So it has to invest more and more each year just to maintain a constant rate of growth. Obviously, this reachs a limit. The entire GDP cannot be invested. The IMF and others assume that China will be able to rebalance its economy and get more growth from domestic consumption while getting a bit less from investment. But the experience of other Asian countries over the past fifty years suggests that this rebalancing is extremely difficult to achieve. Maybe China will prove the exception, but its efforts in this regard so far are not impressive.

So, while the idea of China rushing past the United States in the global GDP sweep stakes makes for dramatic headlines, it isn’t going to happen any time soon.