How big is China’s economy?

by Misa Ogawa, Pamela Cox, and Kevin Rafferty

HONG KONG — There was much fanfare last month when Beijing reported that China had overtaken Japan to become the second biggest economy in the world. But this celebration was bogus — because the reality is that in real terms China has already become the biggest economy in the world, edging slightly past the United States.

The answer to how this can be true, only second last month and now the biggest in the world, is that the measurements are different. In market prices, China’s gross domestic product (GDP) is $5.88 trillion, far behind the $14.6 trillion of the U.S. But in terms of output volume, China is worth $14.8 trillion, more than the U.S.’ $14.6 trillion.

More and more international bodies, such as the International Monetary Fund (IMF), World Bank and Organization for Economic Cooperation and Development, recognize the limitations of market exchange rates in assessing economic strength across international borders. You only have to look at the controversy over whether China’s renminbi is manipulated, messaged or otherwise undervalued to appreciate this. The CIA World Factbook comments that, “Because China’s exchange rate is determined by fiat, rather than by market forces, the official exchange rate measure of GDP is not an accurate measure of China’s output.”

Prices of goods and services are typically far cheaper in developing countries where labor and other costs are less. This is especially so for the wide range of things, including medicine, retail and construction activities, even haircuts and taxi rides, which are not traded across borders. Purchasing power parity (PPP) is an alternative measure of economic reality, using output according to volume rather than price.

But since 2005 the common PPP calculations have been flawed, argues Arvind Subramaniam, senior fellow at the Peterson Institute for International Economics, in claiming that China’s economy is bigger than that of the U.S.

The IMF in October 2010 put China’s GDP PPP at $10.084 trillion. Subramaniam takes issue with the IMF figures. He criticizes a major 2005 revision based on a project by the International Comparison of Prices (ICP). As a result of this, GDP figures for China and India were revised downward by 40 percent. The 2005 revisions form the basis for subsequent IMF PPP figures.

Many economists have cast doubt on the ICP work because of an urban bias in its price sampling in China: It used data from 11 cities and suburbs but no rural prices, partly because of the refusal of the Chinese authorities to allow collection of rural data. Subramaniam uses corrections for these biases in the latest version 7 of the Penn World Tables from the University of Pennsylvania, probably the most respected international comparisons of production, income and prices. China’s PPP-based GDP has been revised upwards by 27 percent for 2005 (and India’s by 13 percent) as a result of the corrections.

In addition, Subramaniam makes further adjustments to take account of what has happened since 2005, and this takes him into the controversial area of exchange rates. He argues that IMF data at face value lead to an “implausible” increase in the real cost of living in China relative to the U.S. (equivalent to a real appreciation of the Chinese currency) of 35 percent. Most of the real exchange rate indexes for China, including those of the Bank for International Settlements, as well as analysis of productivity differentials between China and its trading partners in the IMF’s Article IV consultation last year, point to currency appreciation of 10 to 15 percent.

Having made adjustments of 27 percent for the revisions to the 2005 estimate and of 20 percent for lower cost of living rises, Subramaniam lifts the true PPP measure of China’s GDP by 47 percent, giving China $14.8 trillion against the $14.6 trillion of the U.S. He concedes that the difference is so small as to be within the margin of error.

Subramaniam’s claims are only slightly ahead of other respectable and respected forecasts. The Conference Board, the U.S. economic research association, said in November that China would overtake the U.S. by next year. Perhaps more worrying for the U.S., which has been used to being the world’s top dog, is that the Conference Board predicts that by 2020 China’s output will be almost half that of the U.S., and China will account for 24.1 percent of world output, against only 14.8 percent by the U.S.

What does it matter — or is it all a case of lies, damned lies and statistics (being the most damnable of all lies)? If you could put all the economists in the world together and get them to reach a conclusion, it would make little difference to the lives of anyone, whether in China or the U.S. It does mean that at a stroke China achieves a real symbolic victory. It also means that the per capita income of Chinese vaults to $11,047 (from $7,518 under the old PPP method and $4,283 at market exchange rates).

Of course, having a much higher income in real U.S. dollars does not give the ordinary poor Chinese an extra meal or haircut or even money for a taxi ride. China remains a relatively poor developing country because of its large and sprawling population, but these revisions do give it a significant lift up the global table. If other countries stay the same, the revision lifts China by 20 places to 72nd, just below Brazil and above Iran in the per capita league.

If China is the biggest economy in the world, it can also argue for a bigger role, for example in international institutions: why should the U.S. hold 16 percent of the voting rights and effective veto in the IMF and World Bank if China is bigger? But being the world’s biggest economy also implies responsibilities and a spotlight that the rulers in Beijing may wish to avoid. If per capita income is more than $11,000 in real terms, what is the gap between rich and poor, and is Beijing doing enough to lift the millions of rural have-nots? Is it spending too much on the military? Is it captive of narrow mercantile forces that will lead it and the world into disaster?

Professor T.N. Srinivasen of Yale University argues that China tends to exaggerate its growth rate to demonstrate its strength and dynamism, but understates its level of GDP so that it can present itself as a poor country that should be exempted from bigger contributions to global public goods.

China’s Premier Wen Jiabao and the mainland’s security forces in their different ways, probably prompted by demonstrations in the Middle East rather than Subramaniam’s GDP revisions, have belatedly realized that it is not only the quantity of growth that counts but its quality and where it is spread.

Kevin Rafferty is editor in chief of PlainWords Media