China: Set to Become World’s Largest Economy - Does Size Matter?

The World Bank recently published a report that has sent a shockwave of speculation throughout the financial community.

The World Bank recently published a report that has sent a shockwave of speculation throughout the financial community. The report reveals that in terms of buying power, China is set to become the largest economy by the end of 2014, overtaking the US after more than a century of being in second place.

The latest figures, updated by the World Bank for the first time since 2005, also found that India has overtaken Japan to become the world's third largest economy. The size of the Indian economy almost doubled from 19% of the US in 2005 to 37% in 2011, according to the report.

However, the World Bank has changed its methodology since the report was last published in 2005, now basing its findings on Purchasing Power Parity (PPP) which is an economic theory estimating the amount of adjustment required on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power. In other words, the exchange rate is adjusted so that a unit of currency of one country will have the same purchasing power in a foreign country.

The Economist illustrated the whole issue of PPP simply and humorously when it first published the now famous Big Mac Index in 1986. The Index shows the prices of McDonald's Big Mac hamburgers around the world and compares them in a common currency, the US dollar, at the market exchange rate. This provides a measure of whether a currency is overvalued or undervalued relative to the dollar at the current exchange rate and it illustrates the purchasing power of the currency as in the PPP method used by the World Bank in its latest report.

The trouble with 'burgernomics' as it is now termed, is that it doesn't take into account the variation of the product in different countries. Despite McDonalds being a franchise there are going to be inevitable differences in the basic product. For example, a Big Mac in the US may be larger than those in Romania and sourced from different suppliers at different rates. Then of course, there are the differentials in salaries, utility costs and other overheads which don't appear to be taken into account by the index.

Nevertheless, this exact principal has been applied by the World Bank in their latest reports and what we are being told is that the purchasing power of the yuan will exceed that of the dollar by the end of the year, and also - the rupee is already worth more than the yen.

But does it mean that whoever is at the top slot in the World Bank rankings has the most powerful economy?

Not really. Even if China becomes the number one global financial superpower, it would just serve to conceal the reality of the economy's huge weaknesses. Some of the factors that have driven China's GDP upward are also signs of the nation's deteriorating economic health, ie investment in excess capacity, the construction of wasteful real estate projects and the build-up of insane levels of debt.

In fact, China is fast losing its cost competitiveness and still lags behind in managerial expertise, technology and financial professionalism which are crucial in developing a truly advanced economy.

Despite Beijing's leadership embarking on an ambitious program of reform to make the state-led economy more market-orientated and give private business greater sway, the challenges of implementing these reforms are huge and could cause dramatic economic slowdown, or even worse. With spiralling house prices, large-scale bankruptcy of property developers and a massive issue with shadow financing similar to the US sub-prime debacle that caused the financial crisis in the first place there are many economists who expect China to have a full-blown financial crisis of its own.

On the flip side, if the US slips from the number one slot at any stage in the future, it will not really make a huge difference to the financial community. The dollar will remain the global trading currency and the US will retain its status as the world's financial centre and so nothing really will change.

It's more about what you do with an economy than its size that matters.


- Monday 12 May 2014

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