Is China poised to surpass the United States to become the world’s largest economy? The International Monetary Fund recently predicted that the size of China’s economy would overtake that of the US in terms of purchasing power parity (PPP) by 2016.
But a recent co-authored study by Robert Feenstra, an economist at the University of California, Davis, shows that global economic leadership would pass to China in 2014. And, even more radically, Arvind Subramanian of the Peterson Institute of International Economics argues that China actually surpassed the US in PPP terms 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 could 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 consists in 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% or more of household expenditure in a typical developing country, whereas the figure is less than 20% 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% and 80%, respectively.
Suppose, further, that 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% poorer than a person in the first country!
This absurd result is possible only because PPP is comparing two different consumption bundles. But the consumption basket of an average Chinese is vastly different from the consumption basket of an average American, so PPP comparisons between China and the US can be misleading.
PPP gives an answer to the following question: how much does a Chinese need to earn to maintain his quality of life in China when he moves to the US?
But 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% appreciation of RMB increases the purchasing power of a Chinese person in the US by exactly 10%, whereas his life quality does not change in PPP terms.
But China would surpass the US in a relatively short period of time even if we measured both countries’ economies in nominal terms. Assuming that the Chinese and US economies grow, respectively, by 8% and 3% in real terms, that China’s inflation rate is 3.6% and the US’s is 2% (the averages of the last decade), and that the RMB appreciates against the dollar by 3% per year (the average of the last six years), China would 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% growth for China may or may not be a sure bet. But if China grew by 9-10% in the first five years and by 6-7% in the next five years, the target for an average of 8% between now and 2021 would 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 US's GDP, this demand will become stronger. By almost all recent estimates, China has little time to prepare.