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Just a coronation

Why its becoming economy No 1 is not causing excitement, within China or outside.

Written by Minxin Pei | Updated: June 27, 2014 8:28 am
China is an economic giant, but a financial midget. Its currency is non-convertible and lacks the coveted status of a global reserve currency. (Source: Reuters) China is an economic giant, but a financial midget. Its currency is non-convertible and lacks the coveted status of a global reserve currency. (Source: Reuters)

The day China surpasses the US as the world’s largest economy may be only months away according to the World Bank.

Based on purchasing power parity (PPP), the Chinese economy is expected to be $16.72 trillion by the end of 2014, roughly $100 billion larger than the US economy. Before the recent announcement by the International Comparison Programme of the World Bank, which projected the size of the Chinese economy at the end of this year on the basis of the differential growth rates between China and the US in recent years, the most optimistic estimate suggested that China would seize the number one spot from the US in 2019. (The US has held the top position since 1872.)

The reason it took China five years less to surpass the US was simple: the global financial crisis dramatically slowed down the US economy while the Chinese economy has continued its rapid, albeit decelerating, growth.  Between 2011 and 2014, the US registered a cumulative growth of 7.6 per cent, compared with China’s 24 per cent.

While the projection became headline news in several major Western papers, the reaction in China has been muted. Instead of celebrating the dethroning of America, the Chinese government all but ignored the report. Official news outlets did not carry the story. Global financial markets and the business community barely paid any attention.

It is easy to explain why the report failed to stir much excitement. For Beijing, which actually tried to lobby the World Bank to not include any reference to China’s newfound status, overtaking the US may fulfil a long-sought national goal but may also carry serious downside risks.

As the world’s largest economy, China will likely be called on to contribute more funds for development assistance and shoulder greater international responsibilities. In global climate talks, China may also have a harder time insisting that, as a developing country, it should pay less than wealthy countries. In China, awareness of the country’s top position could bring unwelcome pressure on the government, which spends less than 15 per cent of its budget on social welfare programmes (compared with 37 per cent in the US).

Even for China’s pragmatic ruling elites, it is hard to see any real benefits from the World Bank’s declaration. Using PPP to measure the size of the Chinese economy is just an accounting exercise. The most important economic objective for Chinese leaders is to sustain growth and achieve technological upgrading. They understand only too well that China may be big, but it is also decades behind the US in terms of technological sophistication, innovation, and economic efficiency.

The international business community’s subdued response is also easy to understand. The market has already priced in China’s enormous gains in the global economy. That is why commodity prices, ranging from iron ore to crude oil, have risen several times in the last decade, during which China dramatically closed its gap with the US. Moreover, since most services are not tradable, a PPP-based GDP is a reliable measure of the real standard of living, but not much else.

When it comes to measuring a country’s economic importance and opportunities, what the international business community really cares about is its per capita income, direct influence in the global financial markets and short-term prospects.

Against these measurements, China is definitely not the world’s number one economy. Chinese per capita income, which determines personal consumption power, is a fifth of the US’s in PPP terms. In exchange rate terms, per capita income in China is only one-eighth of that of the US. As a middle-income country, China has a much smaller consumer market than the US.

In addition, large economies must be major players in international finance to have influence around the world. Here, again, China comes up short. The country is an economic giant, but a financial midget. Its currency is non-convertible and lacks the coveted status of a global reserve currency. Its internal financial markets are essentially closed to the outside world due to capital controls, limiting opportunities for both domestic and foreign investors. The mismatch between the large size of the Chinese economy and its global financial influence will continue for an extended period since the country needs to build a strong, well-regulated and sophisticated financial system before opening its capital account and making its currency fully convertible.

Finally, market participants are notoriously focused on a country’s short-term prospects. China does not excite investors now, mainly because the international business community is worried about its near-term challenges, such as the possible collapse of its real estate bubble and the resultant crisis of credit default in its financial system.
The coincidence of China’s imminent coronation and the likely bursting of its credit bubble inevitably invites comparison with Japan of the late 1980s. Japan was then assumed to be on course to surpass the US as the world’s largest economy. Books about Japanese economic superiority and American decline filled bookstores. Yet, within a few years, Japan’s economic bubble collapsed and the country sank into two decades of stagnation.

This historical parallel may mean nothing to the diligent economists at the World Bank, but Chinese leaders apparently know very well that “pride comes before the fall”.

The writer is professor of government and non-resident senior fellow at the German Marshall Fund of the US

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