Sep 24th 2011 | from the print edition
IN 2010 CHINA shot past Japan to become the world’s second-largest economy (based on current market prices). But when might it supplant America at number one? The answer depends on how the exchange rates are calculated. The IMF’s forecasts and the long-run tables of GDP compiled by the late Angus Maddison, an economic historian, are based on purchasing-power parity (PPP), which makes allowances for the lower prices of non-traded services in poorer countries. On that basis, the size of China’s economy is already close to America’s and is likely to overtake it by 2016.
China is further behind when its economy is measured in current dollars (and much further in terms of GDP per person). America’s GDP in 2010 was $14.5 trillion at current market prices; China’s was $5.9 trillion. How quickly the gap is closed depends on three things: the relative speed of real GDP growth in China and America respectively; the inflation gap between the two economies; and the rate at which the yuan rises or falls against the dollar.
The Economist has crunched the numbers and found that, based on reasonable assumptions about these three variables, China could overtake America in the next decade. Its economy has grown by an average of more than 10% a year over the past ten years. As the country gets richer and its working-age population starts to shrink, that growth rate is likely to tail off to perhaps 8% soon. For the American economy the calculation assumed an average annual growth rate of 2.5%.
Inflation tends to be higher in fast-growing emerging economies than in slow-growing rich ones. This is because of the Balassa-Samuelson effect, named for the two economists who first explained it. Fast productivity growth in export industries raises average wage costs across the economy, including in non-traded services where productivity is sluggish. That in turn pushes up average inflation. Our projection assumes a 4% inflation rate in China compared with 2% in America.
The third factor is the exchange rate. To sustain its catch-up with America, China needs to rebalance its economy away from exports towards consumer spending, which will require a rise in its real exchange rate. Some of this will come from having a higher inflation rate than its trading partners. But China’s large current-account surplus and America’s big deficit also suggest that the yuan will have to become much stronger and the dollar much weaker. We have allowed for an extra 3% annual rise in the yuan against the dollar on top of the inflation gap of two percentage points. That implies a slight slowdown in the yuan’s recent appreciation.
If all this comes to pass, China’s economy will be bigger than America’s by 2020. On a different set of assumptions—a Chinese growth rate of 6%, an American one of 3% and an appreciation of the yuan of 2% a year—the date slips to 2024. Or you can make your own predictions, using The Economist’s interactive chart.
