June 2nd, 2011
04:31 PM ET

When will China’s economy overtake America’s?

Editor's Note: Yao Yang is the Director of the China Center for Economic Reform at Peking University. For more from Yao Yang, visit Project Syndicate and check it out on Facebook and Twitter.

By Yao Yang

BEIJING – 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 U.S. 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 U.S. 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 U.S. 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 U.S.?

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 U.S. 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 the renminbi increases the purchasing power of a Chinese person in the U.S. by exactly 10%, whereas his life quality does not change in PPP terms.

But China would surpass the U.S. in a relatively short period of time even if we measured both countries’ economies in nominal terms. Assuming that the Chinese and U.S. economies grow, respectively, by 8% and 3% in real terms, that China’s inflation rate is 3.6% and America’s is 2% (the averages of the last decade), and that the renminbi 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 U.S. GDP, this demand will become stronger. By almost all recent estimates, China has little time to prepare.

The views expressed in this article are solely those of Yao Yang. Copyright: Project Syndicate, 2011. Here is a podcast of this commentary.

soundoff (11 Responses)
  1. james2

    Oh, so now China is wearing the "developing" mask is it?

    June 2, 2011 at 4:48 pm |
  2. j. von hettlingen

    "Is China poised to surpass the United States to become the world’s largest economy?"
    We will see. No doubt it is already the world's second largest economy! Good for the country! The question is – are the Chinese happy to live a hollow life? They are the biggest consumers of luxury goods and cars. Yes they have worked hard, put up with deprivations without complaint and now the regime rewards them for their endurance and apolitical attiitude! What a treat! Yet what about intellectual nourishment, the freedom to think and thrive philsosophically?

    June 2, 2011 at 5:23 pm |
  3. xie

    von, how do you know China does not have intellectual nourishment, the freedom to think and thrive philsosophically? Because you media tell you? If you can vote in a two-party dictatorship, then you don't have a hollow life?

    June 2, 2011 at 7:03 pm |
  4. j. von hettlingen

    The masses reflect the behaviour and mindset – consumerism: German cars, French and Italian luxury goods, Swiss watches etc. Status symbols define the person, not his or her natural values.
    How many in China read Confucius, Mencius or Lao Tse today? There are – in percentage – more in Europe and America that read Aristotle, Socrates, Platon tec.

    June 3, 2011 at 3:17 am |
  5. Hu JinTao

    China will surpass US in 2020. The manufacturing share of China’s GDP is twice that of the US. This means Chinese will produce twice the guns and butter than the US in 2020. Soviet Union had only a third of US GDP. Reagon took the adventage won the arm race. After 2020, new arm race will begin.

    June 3, 2011 at 11:46 am |
  6. Carla

    This article doesn't take into account China's rising water shortage. At some point, China will have no choice but to face it's pollution problem. They expanded at such a fast rate that regulation is lagging behind. They have sacrificed their environment for the sake of economic expansion at a high cost. Their ecosystem and food chain is contaminated with carcinogens and heavy metals. I would prefer to be second or even lower if it meant having clean water, air and safe food for myself and my family. With their environment under such extreme stress, the drought is far more devastating than it should be.

    June 6, 2011 at 12:15 am |

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