How will we really know when China overtakes the US?

Headlines around the world this week trumpeted a watershed moment for the global economy. As the Financial Times put it, “China poised to pass US as world’s leading economic power this year.” This is a startling development – or it would be if the claim were not essentially wrong. In fact, the United States remains the world’s largest national economy by a substantial margin.

The story was based on the 29 April release of a report from the World Bank’s International Comparison Program. The ICP’s work is extremely valuable. I eagerly await and use their new estimates every six years or so, including to look at China.

The ICP data compare countries’ GDP using purchasing-power-parity (PPP) exchange rates, rather than market rates. This is the right thing to do when looking at real (inflation-adjusted) income per capita in order to measure people’s living standards. But it is the wrong thing to do when looking at national income in order to measure the country’s weight in the global economy.

The bottom line is that, by either criterion – per capita income (at PPP exchange rates) or aggregate GDP (at market rates) – the day when China surpasses the US remains in the future. This in no way detracts from the country’s impressive growth record, which, at about 10% per year for three decades, constitutes a historical miracle.

At market exchange rates, the American economy is still almost double the size of China’s (83% larger, to be precise). If the Chinese economy’s annual growth rate remains five percentage points higher than that of the US, with no significant change in the exchange rate, it will take another 12 years to catch up in total size. If the differential is eight percentage points – for example, because the renminbi appreciates at 3% a year in real terms – China will surpass the US within eight years.

The PPP-versus-market-exchange-rate issue is familiar to international economists. This annoying but unavoidable technical problem arises because China’s output is measured in renminbi, while US income is measured in dollars. How, then, should one translate the numbers so that they are comparable?

The obvious solution is to use the contemporaneous exchange rate – that is, multiply China’s renminbi-measured GDP by the dollar-per-renminbi exchange rate, so that the comparison is expressed in dollars. But then someone points out that if you want to measure Chinese citizens’ standard of living, you have to take into account that many goods and services are cheaper there. A renminbi spent in China goes further than a renminbi spent abroad.

For this reason, if you want to compare per capita income across countries, you need to measure local purchasing power, as the ICP does. The PPP measure is useful for many purposes, such as knowing which governments have succeeded in raising their citizens’ standard of living.

Looking at per capita income, even by the PPP measure, China is still a relatively poor country. Though it has come very far in a short time, its per capita income is now about the same as Albania’s – that is, in the middle of the distribution of 199 countries.

But Albania’s economy, unlike China’s, is not often in the headlines. That is not only because China has such a dynamic economy, but also because it has the world’s largest population. Multiplying a middling per capita income by more than 1.3 billion “capita” yields a big number. The combination of a large population and a medium income gives it economic power, and also political power.

Similarly, we consider the US the number-one incumbent power not just because it is rich. If per capita income were the criterion by which to judge, Monaco, Qatar, Luxembourg, Brunei, Liechtenstein, Kuwait, Norway, and Singapore would all rank ahead of the US. (For the purposes of this comparison, it does not matter much whether one uses market exchange rates or PPP rates.) If you are shopping for citizenship, you might want to consider one of those countries.

But we do not consider Monaco, Brunei, and Liechtenstein to be among the world’s “leading economic powers,” because they are so small. What makes the US the world’s leading economic power is the combination of its large population and high per capita income.

It is this combination that explains the widespread fascination with how China’s economic size or power compares to America’s, and especially with the question of whether the challenger has now displaced the long-reigning champion. But PPP exchange rates are not the best tool to use to answer that question.

The reason is that when we talk about an economy’s size or power, we are talking about a broad range of questions – and a broad range of interlocutors. From the viewpoint of multinational corporations, how big is the Chinese market? From the viewpoint of global financial markets, will the RMB challenge the dollar as an international currency? From the viewpoint of the International Monetary Fund 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 involving total economic heft, the indicator to use is GDP at market exchange rates, because what we want to know is how much the renminbi can buy on world markets, not how many haircuts or other local goods it can buy back home. And the answer to that question is that China can buy more than any other country in the world – except the US.

Published in collaboration with Project Syndicate.

Author: Jeffrey Frankel is a professor at Harvard University’s Kennedy School of Government and previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research.

Image: A yuan banknote is displayed next to a U.S. dollar banknote (back) for the photographer at a money changer inside the Taoyuan International Airport March 18, 2010. REUTERS/Nicky Loh