Today’s Headlines: China’s Economy Overtakes the U.S.

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Today’s Headlines: China’s Economy Overtakes the U.S.
December 16, 2017

China’s Economy Is Now Larger Than the U.S. Economy…Maybe

The United States has been the world’s largest economy since 1872, when it wrested the top spot from the United Kingdom. However, a recent announcement by the International Monetary Fund (IMF) suggests that the U.S. has ceded the title to China – at least by one economic standard.

Measured by gross domestic product (GDP), the total value of goods and services produced by a country, the United States economy is still the largest by far. The U.S. GDP value was $16.72 trillion in 2013 compared to $9.33 trillion for China, and 2014 estimates are $16.27 trillion and $8.06 trillion respectively.

However, comparing GDPs of different nations requires conversion to a common currency (typically the U.S. Dollar), and exchange rates do not necessarily reflect the differences in purchasing power that GDP numbers represent within each economy.

In the Chinese economy, prices on many goods are lower because costs are lower (labor costs, for example). Therefore, the same U.S. dollar value generally buys you more of the same goods and services in China than it will within the U.S.

The IMF compensates for this phenomenon with a second economic measure known as purchasing power parity (PPP), which includes measures of the cost of living and relative purchasing power. In that measure, according to IMF estimates for 2014, the Chinese economy surpassed that of the U.S. – $17.6 trillion for China compared to $17.4 trillion for the U.S.

Should We Be Concerned?

Your level of concern would depend on whether you consider GDP or PPP the better measure of an economy’s size and strength — and also upon your degree of nationalistic pride.

MarketWatch argues that PPP is the correct measure of “real” goods and services by removing exchange rate fluctuations to reflect actual economic output. By that logic, the Chinese economy is outpacing ours and will continue to do so based on IMF estimates.

Investor’s Business Daily suggests this is much ado about nothing. In a post by Terry Jones, PPP is called “a phony comparison using a made-up number.” Jones suggests that China likely never will overtake us in nominal GDP, because China’s phenomenal growth is slowing. (US economic nationalists, take heart!)

The Economist notes that China should also overtake the U.S. in nominal GDP sometime in the near future, assuming their economy continues with a 7.75% growth rate. They created an interactive graph on their website allowing you to put in your assumptions and predict the crossover point (the Economist now pegs this at 2021).

GDP or PPP?

Which measure is better? They both have a place. In general, GDP and PPP are relatively close for developed countries but significantly different for emerging markets (which, believe it or not, China is still considered to be).

GDP tends to make more sense when comparing financial flows between countries, because the currency exchange rate directly affects the transaction. PPP is a more of a measure of internal economic strength, since it removes the distortion of applying currency rate exchanges to labor-intensive services that are not internationally traded (haircuts are an oft-used example). Therefore, GDP seems like a more logical method to compare the size of economies of different countries,

What about GDP per capita? That is another useful internal comparison – and it shows a stark difference with $50,979 in the U.S. versus $5,947 in China – but this is by definition skewed for population and says nothing about the size of the economy. For example, Luxembourg has a per capita GDP of $105,119.

China’s population is over four times that of the U.S. (1.34 billion vs. 0.311 billion), so per capita GDP inherently looks worse for China.

The Takeaway

Aside from being an excuse to wave our arms and lament the United States’ perceived declining role in the world, there really is no practical effect of this announcement on stocks, bonds, or investments of any sort. It does, however, carry some psychological impact.

For investment purposes, you should not care how big an economy is, but how healthy it is. Is the Chinese growth sustainable? For that matter, is our growth sustainable? Further, your focus should be on individual stocks rather than the total market.

The Chinese stock market has shot up in the last two weeks, but The Economist attributes this to short-term easing of monetary policy as opposed to long-term growth expectations. Many of the same arguments apply to China’s economy as it does to ours – are we both heading toward another stock market bubble?

In both China and the U.S. the amount of private debt relative to the GDP is fairly disturbing and suggests some correction is inevitable – an article in The Atlantic points out a correlation between this rise and major financial crises of the past. A correction in 2015 would not be at all surprising.

However, the market will arise from these crises as it always does – so you are likely better off keeping your diversified portfolio and analyzing individual winners and losers to adjust rather than try to get in and out of the market in large scale. Do not overreact to China’s rise by either diving too aggressively into their equities or back out assuming an imminent collapse.

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