China as number one

This column was first published in the June edition of Fund Strategy.

A momentous event in modern world history is scheduled for 2 November. That is the day China is scheduled to overtake America as the world’s largest economic power.

The forecast is not by some crank but by Kaushik Basu, the chief economist at the World Bank. He calculated it by taking new estimates of GDP made by his organisation’s International Comparison Program (ICP) and extrapolating them with forecast economic growth rates.

Admittedly his use of a precise day was not meant entirely seriously but it is clear that, using the new figures, China should surpass America as the world’s largest economy some time this year.

In principle, GDP is a simple measure. It is essentially the value of goods and services produced in a country in a year. Having said that, there are three ways in which it can be calculated: by output (measuring the value of output in the whole economy), by income (adding up the income of all residents) and by expenditure (the total spending on goods and services by all residents).

In theory, these measures should all be equal but in practice they seldom are. Things start to become even more complicated when international comparisons are made. That is because the cost of living varies from country to country.

Burgers are the classic example. According to data from The Economist, a Big Mac cost $4.62 in America in January 2014 but the equivalent of only $2.74 in China. That meant, at least as far as burgers were concerned, a dollar bought a lot more in China than in America. Of course, in real life, people do not live by burgers alone but instead purchase a basket of goods and services. The World Bank’s ICP is essentially a way of determining the relative prices of such baskets in different countries. It is based on household surveys carried out every few years. The recently published figures were based on 2011 data.

Such surveys open up the way to have two sets of figures for comparing international GDP. The figure at current prices measures the size of a country’s GDP in actual cash dollars. So China’s GDP at current prices in 2013 was estimated at $9,181 billion, according to the International Monetary Fund (IMF).

The alternative method, which takes into account the cost of living, is expressed in international dollars. In China’s case it was $13,395 in 2013. The discrepancy with the cash figure comes about because a dollar in China can buy considerably more than the same dollar in America. This adjustment is based on what is known as purchasing power parity (PPP). A quirk of the system is that the America’s GDP is the same by both measures because it provides the benchmark against which international comparisons are made.

It should now be clear that the Chinese economy will shortly overtake the America’s in PPP terms only. However, it will be several more years before China is number one in GDP as measured by current prices. The exact year will depend on the growth rates in America and China.

This year, then, China will in real terms, when adjusted for PPP, consume more in total than America. Despite this shift, America will still be way ahead in terms of consumption per head since its population is about 320m compared with 1.3 billion for China.

The picture looks quite different in current dollars. America is substantially ahead of China in absolute terms and will remain so for years to come. In terms of GDP per head, its lead is even greater.

Of course, other factors need to be taken into account when comparing the relative strength of two nations. America has a lead over China in many dimensions, including the international role of the dollar, the quality of its technology and military strength.

However, it would be a mistake to dismiss China overtaking America by one measure of GDP as irrelevant. For a start it is important in symbolic terms. China is about to overtake America in a widely used measure of economic output.

China is still some distance from being the world’s number one power but the gap with America is closing fast.