Hitting the big time soon

PPP comparisons can be misleading, but China’s economy will surpass the US’ by 2021 even in nominal terms

Is China poised to surpass the United States as the world’s largest economy? The International Monetary Fund recently predicted that the size of China’s economy will overtake that of the US in terms of purchasing power parity (PPP) by 2016.

Even more radically, Arvind Subramanian of the Peterson Institute of International Economics argues that China actually surpassed the US in terms of PPP in 2010.

Purchasing power parity measures a country’s income using a set of international prices applied to all economies. Prices in developing countries are usually lower than in the developed countries. Therefore, their income can be underestimated if calculated only according to the exchange rate. Income measured in PPP helps to avoid this problem.

But estimating PPP income raises its own set of problems. One is the fact that every country has a different consumption basket, with the greatest disparity between developing and developed countries. For example, foods usually account for 40 per cent or more of household expenditure in a typical developing country, whereas the figure is less than 20 per cent in most developed countries.

The purpose of PPP comparison is to measure a country’s real quality of life. In this case, it can be thought of as comparing each country’s aggregate good, composed of the goods in each country’s consumption basket. But this aggregate good does not have the same components across countries. That is, PPP calculations effectively compare apples with oranges.

This argument may sound technical, but it has profound implications for cross-country comparisons of life quality.

Suppose we compare two countries. One of them is agriculture-based, and people consume only food, while the other is industry-based, and people not only consume food but also buy clothes. The share of their expenditure on these two items is 20 per cent and 80 per cent, respectively.

Suppose, further, that the per capita nominal income at the market exchange rate in the second country is four times higher than in the first. Food prices are the same in the two countries, while in the second country, the price of cloth is five times higher than the price of food.

In this example, the price of the aggregate good in the second country is 4.2 times the price of the aggregate good in the first country. Further calculation reveals that, in PPP terms, a person in the second country is 5 per cent poorer than a person in the first country!

This absurd result is possible only because PPP is comparing two different consumption bundles. The consumption basket of an average Chinese citizen is vastly different from the consumption basket of the average US citizen, so PPP comparisons between China and the US can be misleading.

PPP gives an answer to the following question: How much does a Chinese person need to earn to maintain the quality of life he enjoyed in China when he moves to the US?

This question is neither intuitive nor realistic. When it comes to the comparison of purchasing power in the international market, a more sensible question is: How many goods can a Chinese buy in the US using the income he earns in China? One must rely on nominal income to provide an answer to this question. In this case, a 10 percent appreciation of the renminbi increases the purchasing power of a Chinese person in the US by exactly 10 per cent, whereas his life quality does not change in PPP terms.

China’s economy will surpass the US’ economy in a relatively short period of time even if we measure both countries’ economies in nominal terms. Assuming that the Chinese economy grows by 8 percent and that of the US 3 percent in real terms, that China’s inflation rate is 3.6 percent and America’s is 2 percent (the averages of the last decade), and that the renminbi appreciates against the dollar by 3 percent per year (the average of the last six years), China will become the world’s largest economy by 2021. By that time, both countries’ GDP will be about $24 trillion, perhaps triple the size of the third largest economy, either Japan or Germany.

Assuming 8 percent growth for China may or may not be a sure bet. But if China grew by 9-10 percent in the last five years and grows by 6-7 percent in the next five years, the target for an average of 8 percent between now and 2021 will be met.

The world has already begun to demand that China assume greater responsibility for the global economy’s health. As China’s economy continues to grow and eventually matches the GDP of the US, this demand will become stronger. By recent estimates, China has little time to prepare.

Yao Yang is the director of the China Center for Economic Reform at Peking University.

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