Blog Post - Views on the Economy and the World

China is Not Yet #1

| May 08, 2014
Widespread recent reports have trumpeted: “China to overtake US as top economic power this year.”  The claim is basically wrong. The US remains the world’s largest economic power by a substantial margin.

The story was based on the April 29 release of a report from the ICP project of the World Bank: “2011 International Comparison Program Summary Results Release Compares the Real Size of the World Economies.”     The work of the International Comparison Program is extremely valuable.  I await eagerly their latest estimates every six years or so and I usethem, including to look at China.  (Before 2005, the data collection exercise used to appear in the Penn World Tables.)

The ICP numbers compare countries’ GDPs using PPP rates, rather than actual exchange rates.   This is the right thing to do if you are looking at real income per capita in order to measure people’s living standards.  But I would argue that it is the wrong thing to do if you are looking at national income in order to measure the country’s weight in the global economy.

The bottom line for China is that by both criteria, income per capita (at PPP rates) or aggregate GDP (at actual exchange rates), it still has a ways to go until the day when it surpasses the US.  This in no respect detracts from the country’s impressive growth record, which at about 10% per annum for three decades constitutes a historical miracle.

ChinaUSGDPgraphblog

(click on the graph for larger image)

At current exchange rates, the American economy is still almost double China’s, 83% bigger to be precise.  But the cross-over day is not far off, as the graph shows.  If the Chinese real growth rate continues to exceed US growth by 5% per annum and the yuan appreciates at 3% a year in real terms (inflation is higher there), then China will pass the US by 2021. Soon, but not imminent.

The PPP-versus-exchange rate issue is familiar to international economists.   This annoying but unavoidable technical problem arises because China’s output is measured in its currency, the yuan, while US income is measured in dollars.  How should you translate the numbers so that they are comparable?  The obvious solution is to use the contemporaneous exchange rate.  (Multiply China’s yuan-measured GDP by the dollar-per-yuan exchange rate, so that is expressed in dollars.)

Someone then points out, however, that if you want to measure the standard of living of Chinese citizens, you have to take into account that many goods and services are cheaper there.   A yuan goes further if it is spent in China than if it is spent abroad.  Some internationally traded goods have similar prices.   T-shirts are virtually as cheap in the United States as in China, in part because we can buy them from there. (Oil is almost as cheap in China as abroad, because it can import oil.)   But haircuts, a service that cannot readily be traded internationally, are much cheaper in China than in the US.  For this reason, if you want to compare income per capita across countries, you need to measure local purchasing power, as the ICP does.

The PPP measure is useful for many purposes, like knowing which governments have been successful at raising their citizens’ standard of living.  A second application is estimatingwhether the country’s currency is “undervalued,” controlling for its productivity.  A third is judging whether it is reasonable to expect that the country has the means to start cutting pollution.   (The turning point for sulphur dioxide in international data has been estimatedat roughly $10,000 per capita in today’s dollars.  China is now there.)

Looking at income per capita, China is still a relatively poor country, even by the PPP measure and even though it has come very far in a short time.  Its income per capita is now about the same as Albania’s, in the middle of the distribution of 199 countries (99th).

But Albania doesn’t often get headlines.   Why are we so much more interested in China?  Partly because it is such a dynamic economy, but not just that.  China has the world’s largest population.  When you multiply a medium income per capita times 1.3 billion “capita,” you get a large number.  The combination of a very large population and a medium income gives it economic power, and also political power.

Why do we consider the United States the incumbent number 1 power?   Partly because it is rich, but not just that.  If income per capita were the criterion, then Monaco, Qatar, Luxembourg, Brunei, Liechtenstein, Kuwait, Norway and Singapore would all rank ahead of the US.  For purposes of that comparison, it does not much matter whether you use actual exchange rates to make the comparison or PPP rates.  Relative rankings for income per capita don’t depend on this technical choice as much as rankings of size do.  (The reason is that the PPP rates are highly correlated with income per capita, the phenomenon known as the Balassa-Samuelson relationship.)

If you are choosing what country to be a citizen of, you might want to consider one of these richest countries.   But we don’t consider Monaco, Brunei and Liechtenstein to be among the world’s “leading economic powers,” because they are so small.  What makes the US the #1 economic power is the combination of having one of the highest populations together with having one of the higher levels of income per capita.

So there is a widespread fascination with the question how China’s economic size or power compares to America’s, and especially whether the challenger has now displaced the reigning champ as #1.  It seems to me that PPP rates are not the best ones for making this comparison.  Why?

When we talk about size or power we are talking about such questions as the following.  From the viewpoint of multinational corporations, how big is the Chinese market?  From the standpoint of global financial markets, will the RMB challenge the dollar as an international currency?   From the viewpoint of the IMF and other multilateral agencies, how much money can China contribute and how much voting power should it get in return?   From the viewpoint of countries with rival claims in the South China Sea, how many ships can its military buy?   For these questions, and most others where the issue is total economic heft, you want to use GDP evaluated at current exchange rates.  It’s how much the yuan can buy on world markets that is of interest, not how many haircuts or other local goods it can buy back home.

It is sometimes objected that using the current exchange rate subjects the comparison to the substantial fluctuations that exchange rates often exhibit.   This is true.   But the large and variable measurement errors in the PPP adjustment are considerably worse.  There is a good case for using a five-year average of the exchange rate instead of the exchange rate in one particular year. It doesn’t make much difference for the US-China comparison during this period.  But even when exchange rate fluctuations seem large, the difference is relatively small compared to the other statistical issues at stake here.

[A shorter op-ed version of this article appeared at Project Syndicate. Comments can be posted there. A version at VoxEU will include references.].
For more information on this publication: Please contact the Belfer Communications Office
For Academic Citation: Frankel, Jeffrey.China is Not Yet #1.” Views on the Economy and the World, May 8, 2014, https://www.belfercenter.org/publication/china-not-yet-1.