Author: Simon Baptist

Location: London

Date: 2014-05-15

The idea that China will overtake the US as the world's biggest economy this year has provided fuel to doomsayers in the latter country worried about the declining influence of the US on the global stage. Previously, based on the last version of PPP exchange rates provided by the ICP in 2005, it had looked like China would surpass the US only in 2019. Within Asia, India has overtaken Japan to become the world's third-largest economy measured under PPP exchange rates. When the ICP made its last revision in 2005, it had ranked India's economy as only the 10th-largest in PPP terms.

Is China really the world's biggest economy?

It is important to note that the ICP has not uncovered new economic activity. The economic "power" of countries like China and India has not risen: global economic transactions are conducted at market exchange rates, not PPP ones. The Economist Intelligence Unit forecasts that China's GDP at market exchange rates will reach US$10.4trn in 2014, but this is still less than 60% of the size of the US economy, at US$17.6trn.

In practice, the use of PPP exchange rates tends to boost the apparent size of developing economies relative to wealthier ones. This reflects the fact that a given amount of US dollars converted at market exchange rates will buy more goods and services in many emerging markets than it will in a developed country. Nonetheless, the task of measuring economic activity at PPP exchange rates remains very difficult. The theory behind the idea is simple: economic output in a country includes many goods that are not tradeable across borders, so using market exchange rates to measure GDP can be misleading if the prices of non-tradeable goods are systematically different. Given that non-tradeable goods, such as restaurant meals or haircuts, are often labour-intensive, the low wages in emerging markets typically mean that this is the case. Furthermore, market exchange rates can also fluctuate violently from year to year, distorting comparisons between economies. The system of PPP exchange rates seeks to produce a way of comparing the prices of a basket of goods and services between countries to produce a measure of performance that counts the quantity of goods and services produced undistorted by such price differences.

There are many flaws in the idea of PPP, however. Perhaps the most important is that finding a basket of goods and services to compare prices between countries is virtually impossible. Countries produce (and consume) very different types of goods and services, and differences in quality are hard to take into account. Food in China may be cheaper than in the US, but consumers in the US do not have to worry to the same extent about food safety because part of the higher price they pay goes towards maintaining a stricter regulatory and monitoring regime. Compounding these concerns, there have been sharp shifts in the PPP exchange rates used by the ICP between 2005 and 2011, which raises questions about the supposed greater stability of PPP exchange rates.

So what use is PPP?

The problems involved in using PPP exchange rates mean that many economists consider market exchange rates the only appropriate measure to use when ranking the sizes of different economies around the world. Certainly, for companies wanting to assess business opportunities, market exchange rates are the ones that matter. The Chinese government appears to share this view, and refused to co-operate with the ICP in its work (raising further questions about the data used for China). The Chinese administration's decision may have been driven in part by a concern that the resulting figures might be used by those arguing that China's growing economic weight means that the country should do more to address global concerns such as climate change.

PPP exchange rates are best used to compare and contrast output per head in various countries, rather than to rank economies in terms of their size. The economic strength of China, India and Indonesia stems partly from their large populations. They are much weaker in terms of output per head, which stood at US$9,202, US$4,960 and US$8,389 respectively in 2011 under the newly updated PPP figures. This compares with US$51,605 in the US and a global average of US$13,258.

Pointing to undervalued currencies

A further use of PPP exchange rates is to gain an idea of which currencies are undervalued. India's and Indonesia's shares of the world economy under PPP measurements, at 6.4% and 2.3% respectively, are around double their shares when measured by market exchange rates. (Both countries have experienced a significant depreciation of their currencies against the US dollar since 2011, which will only have widened the ratio). This suggests that prices for goods and services that are not traded across borders are very cheap in India and Indonesia, even compared with those in many low-income nations in Africa. The price level for government expenditure in Indonesia was particularly low compared with other GDP expenditure components at PPP exchange rates, suggesting that government expenditure could be a more effective way to reduce poverty, which remains endemic in the country. By contrast, the price level for fixed capital formation in India was high. This could reflect a number of factors, including problems such as graft that raise the cost of investment.

Emerging markets come to dominate the global economy

The new PPP exchange rate data have many problems and can be easily misconstrued. Nevertheless, whatever the merits of the figures, they have again drawn attention to a secular trend that is evident whether using PPP or market exchange rates. Emerging markets are accounting for a growing share of global economic output, and Asia's largest economies are leading the charge. Companies that wish to succeed in this global environment will need to follow the money.

 

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