Hamish McRae: The US dollar was once so special. But no longer...

Economic Studies

Wednesday 27 April 2011 00:00
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The moment when China passes the US in economic size is getting closer, at least according to the International Monetary Fund. It has just predicted that this tipping point will be reached in 2016, much sooner than all other predictions, which range from 2020 through to the 2040s.

The reason the IMF reaches this number is that it calculates at purchasing power parity exchange rates rather than market rates. Because the same goods in China are much cheaper than they would be in the States, the Chinese economy works out larger than it otherwise would. You can have a debate as to which rates are more appropriate, but because the dollar is in any case being gradually devalued against the yuan the difference between them will diminish. At any rate the IMF calculates that China's GDP will be worth $19,000bn in 2016, whereas the US GDP will be $18,800bn.

If this were just one of the many economic predictions that are pumped out every week it might have received little attention. What has given it some edge is that it follows the warning that the US might lose its AAA credit rating, fears that it will be unable to correct its budget deficit, and stories that China may shift part of its foreign-exchange reserves out of dollars and into other currencies. So it plays to the sense of decline in the US, as well as to the current swagger of China. It is a story that has been widely reported in Beijing; but what does it actually signify?

In one sense, not a lot, because it tells us what we already know: that within a generation China will become the world's largest economy. The actual tipping point matters little; what matters is the way in which the Chinese economic growth affects us all, most obviously at the moment through high fuel, food and raw material prices. We are already seeing the impact of China's advance every time we fill up the car.

For Britons, brought up in a world where their home country has gradually lost economic influence, this might seem a familiar experience. In absolute terms we have, at least until a couple of years ago, become richer, even though in relative terms we have tended to slip down the world league. For us, all that is happening is a rebalancing of the rest of the world, with Asia going up, and the US and Europe going down.

But if you are in the US what is happening is quite new. It is not just that all Americans have been brought up in a world where the US is the number one economy. Even the US intellectual elite still thinks of America as having a special role in the world, not just in military terms but in financial terms. There is an implicit assumption, particularly among US economists who call for an even larger fiscal boost, that the US government can borrow almost without limit.

In part, that perception of special status remains correct. Why can the US still raise money so cheaply despite its yawning fiscal deficit and, in particular, its seeming inability to deal with it? Because the dollar is still the dominant reserve currency. More than 70 per cent of the currency reserves in the world's central banks are in dollars; the euro is a poor second and the pound and the yen vie for third place. It has suited the rest of the world to preserve the US's financial status, even as it has eaten away at the economic dominance that led to that status in the first place.

As a general rule in financial matters things take longer to happen than you would expect but when they do start to move they happen more quickly. You can see that in what has happened to fringe European government debt. It has been clear for some time that Greek debt will have to be restructured, for the country cannot pay the interest burden imposed on it. But only recently has the price of that debt fully reflected the probability that the debt will not be repaid in full.

The US will retain its special status for some years yet. The dollar will not become an "ordinary" currency, and the US government become subject to the same discipline as the rest of us, as long as the US is clearly the world's largest economy. But once it loses its pole position everything changes. We all know this is going to happen, though it is hard to think through the full consequences. This work by the IMF should nudge us to think a bit harder.

Caution: handle GDP data with care

Here in the UK the focus this week is on what happened to the economy during the first quarter of this year. The preliminary GDP estimates come out this morning and the expectation is for there to be some growth, say around 0.5 per cent, or 2 per cent expressed as an annual rate. Two things give these numbers special significance: the fact that the previous quarter showed a surprise negative of minus 0.5 per cent, and the forthcoming decision by the Bank of England on interest rates. Another negative (though unlikely) would mean the economy had experienced a double-dip recession, which would really set the cat among the pigeons, while a strong positive (say 0.8 per cent growth) might clear the way for a rise in rates next month.

But we should all be careful about drawing forthright conclusions from one set of data, particularly a preliminary one such as this. That negative for the final quarter does not square with other figures, for example for total hours worked, which rose strongly, and it will be interesting to see whether that is revised upwards. Thus GDP growth in the fourth quarter of 2009 has been revised up from an originally reported 0.1 per cent to 0.4 per cent.

So while good figures are always more welcome than bad ones, it is no comment on the competence of the statisticians to say that you should take whatever they say with a pinch of salt. What seems to be happening, confirmed for example by a mixed bag of data from the CBI on industrial expectations yesterday, is an uneven, "two steps forward, one step back" recovery. Expect that pattern to carry on for many months.

h.mcrae@independent.co.uk

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