Hamish McRae: By some calculations, China is already the most important economy in the world

It is the world’s largest importer of raw materials and the biggest importer of oil

Is China really going to pass the US to become the world’s largest economy this year? So say the economists at the International Comparison Program, a Washington-based body which involves the World Bank, the United Nations and some other international agencies.

It is a great headline and one that will reverberate around the world. But are the calculations realistic, and if so, why has China as No 1 happened so much earlier than other economists expected? 

Click image above to enlarge graphic

Some background: the famous Brics report by Goldman Sachs, which really focused attention on the advance of the largest emerging economies, especially China, suggested that it would pass the US some time in the second half of the 2020s.  Goldman’s economic model was built on a number of variables, including the projected size of the working population, some assumptions about the pace of technology transfer and others about rising exchange rates in the emerging world. One key point here is that it took actual exchange rates, not those at purchasing power parity.

This is an important distinction. Purchasing-power parity (PPP) takes into account the fact that many services are cheaper in the emerging world. A car is more or less the same price, net of tax, everywhere. But a haircut is much cheaper in India or China than it is in Europe or North America. If you are interested in relative living standards, PPP exchange rates probably give a better comparison; if you are interested in economic power – whether a country can afford its oil imports or its ability to take over companies abroad – then actual exchange rates are the ones that matter.

Obviously, if you take PPP rates the Chinese economy looks bigger that it would do, relative to the US, than if you take actual exchange rates. But will these boost the size of the Chinese economy enough to enable it to pass the US? Other studies using PPP have suggested that the passing point won’t occur until 2018 or 2020. 

The short answer is that we don’t know. The prime difficulty is adjusting for quality. The most expensive haircut I have had was in the Adlon Hotel in Berlin. It felt wonderful – the person who did it usually prepared opera stars for the stage and this was a bit of jobbing work between tours. The least expensive was in Cairo and caused my colleagues on the paper to erupt in mirth when I got back. And how do you account for haircuts done free by someone in the family? That does not appear in GDP at all.

If there is uncertainty about PPP projections there is also uncertainty about ones done with market exchange rates. As noted, the Goldman model suggests that the passing point will be about 2027, and you can see its projections for the top 10 largest economies in both 2020 and 2030 in the graphs. But a (rather good) study by HSBC a couple of years ago projected the passing point to be much later, not till the 2040s. The argument there was that it was easy for an emerging economy to make massive advances during the catch-up stage but it became progressively harder the closer it got to developed-country income levels.

There is, however, another way of looking at the relative size of economies, which is to focus on particular segments. Thus China is now by far the world’s largest producer of cars: more than 18 million last year. It has more mobile phone connections than anywhere else. And it is the world’s largest importer of most raw materials and the biggest importer of oil.

I usually take the Goldman projections as the most helpful measure of the shift of power from the G7 to the Brics, and some time in the 2020s seems to me the most sensible date to take as a passing point. But the truth is that in many areas of economic endeavour that passing point has already been reached. What can we make of that?

The rise of China is surely the most important economic story of our time and it takes a while to adjust to its significance. Whether China reaches pole position this year, in 10 years’ time, or even later, there can be very little doubt that it will be there within a generation. At one level that is a huge achievement, but at another it is the way things should be. The natural position for China is for it to be the world’s largest economy. It was until the 1890s, when it was passed by the US. Indeed, until the Industrial Revolution transformed first the UK, then Europe and North America, both China and India were far larger economies than anything in what we now call the developed world. (Anyone interested in the progress of the different economies should look at the work of the late Angus Maddison, who modelled how their relative size has shifted over the past 1,000 years.)

But if we should accept that the natural position for China is to be No 1 and be comfortable with this, there are some notes of caution.

One is that this is catch-up, for China has up to now been applying technology developed elsewhere. That will change as education improves, and we should not assume we have any long-term advantage. But the narrower the gap becomes, the harder it will be to close it further.

Another caution is demography, for China is ageing fast and the size of its working population – or rather its population of working age – has started to shrink.

Another widely noted caution is the environment. Much economic activity has ignored the external costs it imposes on this, both at home and abroad.

Nevertheless, these new calculations reflect a certain reality: that on some measures China is now the most important economy in the world.

We should acknowledge that with respect; cautious respect certainly, but respect none the less.

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