Who is the Biggest Economy in the World?

December 23, 2014

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In October, the IMF declared that China was the largest economy in the world–on the basis of purchasing power parity. Now before you get too upset about this statistic, it is important to know that the third largest economy on this basis is not Japan or Germany–but India. Purchasing power parity (PPP) is an attempt to correct reported statistics for the divergence in the cost of living between different locations, much the way that CPI (and similar deflators) try to correct buying power estimates across time. The typical PPP example is the Big Mac Index, a single constant quality item that costs different amounts around the world. In actuality, PPP is based on a basket of goods in the tradable sector.

However, the reality is that the cost of tradable goods is usually heavily based on the underlying cost of non-tradable goods–like rent, medical care and education. These costs are embedded in the labor costs and taxes that determine prices in the tradable sector. Lower tradable goods costs in emerging markets typically reflect the lack of a developed service economy. Thus, PPP adjusted GDP might be thought of as what GDP would be if those countries had a service sector as developed as their tradable goods sector. European nations generally have lower PPP adjusted GDPs than in reality, indicating their higher costs for services–which are often provided less efficiently by governments.

On a per capita basis, still using PPP, the US ranked 10th behind small high flyers like the Gulf States, Singapore, Hong Kong and Switzerland. China is 85th (up from 89th last year) just ahead of the Dominican Republic. India is 125th (of 186) between Vietnam and Nigeria. China’s $12,893 PPP adjusted income looks nice, until one recognizes that every developing country’s income is bumped up. If China grew for another decade at the same torrid pace it did over the past ten years, it would rise to 54th – with a per capita GDP equal to 54 percent of the US level (assuming the US also grew at the same pace as over the past ten years), up from 24 percent today. At that point, China would be where Slovenia and the Czech Republic are today. Bottom line, for the foreseeable future, it is China’s size and influence on global trade that will be of dominant importance, not its quality of life. Chinese growth is certain to slow in the coming decade–likely to a pedestrian 7 percent (5 percent real + 2 percent inflation)–and the adjustment from PPP will diminish as its income rises. Thus, 10 years from now China is likely to be a huge Mexico and not yet European.

This week, China advanced its economy by adopting more international standards in measuring the service sector. This added 3.4 percent, or more than $300 billion, to its reported 2013 GDP. Many analysts expect another 3-5 percent hike is possible if China adopts all international standards. Currently there is no adjustment in China for owners’ equivalent rent–the value most countries include to reflect the rental income that would be generated if homeowners were treated as landlords. Most people in China own their residence, so actual rent is a relatively small share of total GDP. The US boosted its GDP last year when it shifted to counting R&D as capital investment. Nigeria nearly doubled its economy by finding a service sector, leaping it over South Africa as the largest economy on the continent. Bottom line, China will surpass the US as the largest economy on the planet–without needing a PPP adjustment–sometime in the next decade. Yet, the US will remain the dominant developed economy, while China will still be an emerging market. China faces far more challenges in maintaining even a fraction of its historic growth pace, while the US should easily match it 2.7 percent annualized growth (nominal PPP adjusted) of the past decade in coming years.

The preceding is an abridged version of a commentary for McVean Trading and Investments, LLC and has been reposted here with permission of the author.

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

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