Today’s headline in the Financial Times declares, “China poised to pass US as world’s leading economic power this year”. This headline is misleading, however, as deep in the article, it notes that it is using the gross GDP as adjusted by PPP:
The estimates of the real cost of living, known as purchasing power parity or PPPs, are recognised as the best way to compare the size of economies rather than using volatile exchange rates, which rarely reflect the true cost of goods and services …
The article goes on to explain that the IMF has changed their estimate of the PPP for China. This is why they believe that China’s gross GDP as adjusted by PPP will surpass the US this year, instead of in 2016.
A country’s per capita GDP adjusted by PPP is certainly a good way to understand how one country’s standard of living compares with that of another country. However, it is not a good way to compare the size or even the purchasing power of various economies. The reason for this is simple: The PPP shows how far a country’s currency will go within that country. However, when it comes to international trade, the PPP is meaningless, as the value of a currency is defined by exchange rates.
For example, in Shanghai, you can buy a can of soda pop for 2 RMB, which comes out to about 32 cents. However, in Japan that same can will cost about $1.10. One could argue however that in China you can buy a lot more with your RMB than your can buy in Japan with your yen, but that the exchange rate does not reflect this fact. Thus, the exchange rates are adjusted according to PPP so that the prices will be closer to the same, regardless of the country.
There are many, many ways to calculate what the PPP of a currency might be, and no one can agree on methodology. Further, the IMF’s website is such a mess that it appears to be impossible to discover what they think the PPP of the Chinese RMB and the Japanese yen are (I got tired of looking). However, from what I can tell, if $1 is changed into Japanese yen, it will buy the equivalent of about 96 cents worth of goods in Japan compared to in the US, and if it is changed into Chinese RMB it will buy about $1.45 worth of goods in China compared to in the US. On this basis, the price of a can of pop will seem comparatively to be about $1.05 in Japan, and about 46 cents in China. However, it will only seem this way to people living in those countries getting paid in those currencies. To an American tourist visiting these countries, the price of a can of pop will still be $1.10 in Japan, and 32 cents in China.
This brings up a big issue with the PPP. The PPP should adjust the exchange rates to make the cost of a can of pop exactly the same in each country. However, it did not do this, because economies are not just different in scale, but that are different in nature. Soda pop is cheap in China compared to most other countries, but other things are just as expensive in China as in the US and Japan, if not more expensive. The estimates of a currency’s PPP can thus vary widely depending upon what is in the basket of goods that is being used to compare prices. Further, the things in the basket are not necessarily things that people in every country really buy or use.
A bigger issue is that the PPP of a currency is worthless as a measure of comparison when it comes to actual foreign exchange. If I am paid in dollars and am used to living in the US, a can of soda pop will seem expensive to me in Japan, regardless of what the PPP of the yen might be. In the same way, a can of soda pop in China will seems cheap. The only value a PPP has is in determining how an individual perceives the cost of living in his own country, compared to how another individual perceives the cost of living in his own country. The PPP is worthless in telling you how far 1,000 RMB will take you in New York City when changed to dollars, compared to how far 1,000 RMB will take you in Shanghai. And if it worthless for telling you this, then it is worthless when it comes to comparing gross GDP.
The current nominal GDP of China is $8,358,400 million dollars, while the current nominal GDP of the US is nearly double that at $16,244,600 million, and the IMF does not believe this gap will close anytime soon. While the IMF and others may want to adjust the figures using PPP to say that China will soon be more economically powerful than the US, there is no way that China will surpass the US in purchasing power on the international exchange market anytime soon. It has half the purchasing power of the US, and therefore half the economic might compared to the US when it comes to international affairs.
It would be better, if people were going to put out press releases citing PPP, that they would use the PPP for what it was designed for: to show what it is like to live in a country economically, and to compare standards of living.
One way of doing this is by looking at the per capita GDP adjusted by PPP. By nominal per capita GDP, China ranks 83rd in the world at $6,747 per person, while the US is 9th in the world at $53,101 per person. Of course, we already know that within China the RMB has much more buying power than the exchange rate would seemingly indicate, so the nominal per capita GDP does not tell us much. It is better to adjust the nominal per capita GDP by PPP. When we do this, we get a different story. Using this measure, China ranks 93rd in the world at $9,844, while the US ranks 6th (since PPP uses the US dollar as a benchmark, the US’s per capita GDP adjusted by PPP stays the same–only the ranking changes). By any measure, then, the vast majority of Chinese people are dirt poor compared to most westerners. Given the large population of China, its GDP would have to not only surpass the GDP of the US, but in fact be many times larger for this not to be this case.
I am not trying to rain on China’s parade here. Seriously. Rather, until the last few years it had never occurred to anyone to adjust the gross GDP by PPP in order to rank countries. When Japan had the number 2 economy in the world, people certainly never did this. What seems to have occurred is that the whole world has bought into the meme of China rising and that this is China’s century. And, come hell or high water everyone is trying to make this seem true, even when the reality is much more nuanced and complex.
In truth, I wish that China were a more prosperous country than it really is, because its people are so very, very poor. However, wishing will not make this so. Nor will manipulating the data.
It appears that the Chinese government agrees with the assessment given above. According to the WaPo:
China’s National Bureau of Statistics, which took part in the study, rejected its conclusion, according to the World Bank report.
The statistics bureau “expressed reservations” about the study’s methodology and “did not agree to publish the headline results for China,” the report said.
A figure was estimated anyway by researchers, but “the NBS of China does not endorse these results as official statistics,” the report said …
The International Comparison Program, conducted every six years, is meant to allow comparisons of living standards in countries with widely varying prices.
The results are a good tool for understanding living conditions for Chinese families but other uses are limited, said Mark Williams, chief Asia economist for Capital Economics.
“It does bring home the sheer size of the Chinese economy, in the services and goods and that people in China are producing,” Williams said.
“Where it falls short is that it doesn’t really tell us about China’s economic standing relative to the rest of the world,” he said. “When it comes to China’s purchasing power abroad, we need to look at the figures adjusted for market exchange rates.” …
With its much larger population of 1.3 billion people, China barely ranks in the top 100 countries for income per person.
The report is a reminder that Chinese consumers only have about one-tenth as much money to spend as Americans, said economist Brian Jackson of IHS Global Insight. That is about half the world average, on par with the Philippines, Bolivia or Iraq.