China Surpasses America As World’s Largest Economy by Gary D. Halbert
FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 26, 2015
IN THIS ISSUE:
- Economic Reports Suggest a Sluggish Second Quarter
- China Became the World’s Largest Economy in 2014
- Comparing Different Economies by Purchasing-Power Parity
- Should Americans Fear an Economic Crash in China?
Seth Klarman On Margin Of Safety Investing
This is part nine of a ten-part series on some of the most important and educational literature for investors with a focus on value. Across this ten-part series, I’m taking a look at ten academic studies and research papers from some of the world’s most prominent value investors and fund managers. All of the material Read More
For the first time in history, the People’s Republic of China’s Gross Domestic Product exceeded the GDP of America, as measured by purchasing power, in 2014. According to the International Monetary Fund, China’s purchasing power GDP hit $17.6 trillion last year versus $17.4 trillion in the US.
This was an important milestone for both countries, and China will almost certainly expand its lead over the US in the coming years and decades. Yet that is not necessarily a bad thing for the US, as I will explain below. You probably didn’t hear about this in the media, and that’s why we will talk about it today.
But before we get to our main topic, let’s look at a few recent economic reports of interest. The US economy has largely disappointed this year, with weaker-than-expected growth in sales, spending and production, with most of reports showing scant momentum.
Economic Reports Suggest a Sluggish Second Quarter
Most, but not all, of the reports over the last couple of weeks continue to suggest that the economy is still struggling in the 2Q. Retail sales were flat in April after rising 1.1% in March. Industrial production fell in April when the consensus was for a modest increase. Durable goods orders for April came in about as expected at -0.5% following the much stronger reading of 5.1% in March.
On the housing front, building permits and housing starts rebounded above expectations in April, while sales of existing homes fell short of the modest increase in the pre-report consensus. New home sales for April, out this morning, were in-line with the consensus at 517K units and well above the disappointing March reading.
The Consumer Confidence Index came in today at 95.4 for May, above the consensus of 94.0. Yet the University of Michigan Consumer Sentiment Index unexpectedly dropped sharply in early May from 95.9 to 88.6. The Bloomberg Consumer Confidence Index slumped six points to 44. Some 39% of respondents said the US economy is getting worse, the largest share since the federal government shutdown 19 months ago. This Bloomberg Index has dropped for the last six straight weeks.
Consumer spending, which accounts for almost 70% of GDP, climbed only 1.9% (annualized rate) in the 1Q, the slowest in a year and less than half the 4.4% advance in the final three months of 2014. Consumers continue to use their gasoline savings to pay off debt or increase their nest-eggs.
On a positive note, the Labor Department reported last week that initial claims for state unemployment benefits increased only 10,000 to a seasonally-adjusted 274,000 for the week ended May 16.The four-week moving average of claims (considered a better measure of labor market trends since it irons out week-to-week volatility) fell to a fresh 15-year low.
Claims have been running below 300,000, a threshold associated with a strengthening labor market, for 11 straight weeks. This is a rare occurrence that economists say underscores the jobs market’s resilience despite the continued sluggish economy.
The biggest news this week will come on Friday when the Commerce Department releases its second estimate of 1Q GDP. The initial estimate last month had 1Q GDP increasing by a modest 0.2%, well below expectations. Additional data since then suggests that the number will be revised significantly lower on Friday – the consensus is for a drop to -1.0%.
If the 1Q GDP revision comes in as expected, then we can look for forecasters to again lower their growth estimates for the 2Q.
China Became the World’s Largest Economy in 2014
Despite a marked slowdown in its economic juggernaut in recent years, China surpassed the United States as the world’s largest economy in 2014 – as measured by purchasing power – according to the International Monetary Fund. The IMF estimates that China’s GDP rose to $17.63 trillion in 2014 versus the US GDP of $17.42 trillion last year.
And the IMF projects this gap to widen even more this year. The IMF forecasts that China’s GDP will hit $19.23 trillion in 2015 versus $18.29 trillion projected for the US. The gap gets increasingly wider in the IMF’s projections over the next several years. But is that really a bad thing? No, as I will explain below.
Most of the media coverage so far this year has focused on the fact that China’s economy, as measured by GDP output, slowed to the lowest growth rate in almost 25 years in 2014. China’s economic growth slowed to 7.4% (annual rate) last year, down from over 10% as recently as 2010. Never mind that any developed nation on the planet would love to have that level of growth.
Nevertheless, the slipping momentum in China, which reported economic growth of 7.7% in 2013, has reverberated around the world, sending prices for commodities tumbling and weakening an already soft global economy. Yet despite the slowing of China’s economic growth rate, it still managed to surpass US GDP in 2014 in terms of purchasing power.
For the first time in decades, America is not the leading economic power on the planet, as measured by purchasing power. It just happened – and almost nobody noticed or was surprised. With China’s mind-boggling population of 1.36 billion people, versus the US population of 319 million, it had to happen sooner or later.
This moment came sooner than almost anyone had predicted, and that may explain the lack of media attention. This revelation is in large part because of China’s decision last year to report its GDP calculations in line with international standards, which revealed numerous activities that had previously gone uncounted as part of its official GDP.
To put the numbers slightly differently, China now accounts for 16.5% of the global economy when measured in real purchasing power terms, compared with 16.3% for the US, the first time ever for China to surpass the US.
Comparing Different Economies by Purchasing-Power Parity
These calculations are based on a well-established and widely-used economic measure known as Purchasing Power Parity (or PPP), which measures the actual output in the home country’s currency as opposed to in US dollars.
The PPP measure is a better comparison for many purposes. For example, take military spending: the money that China needs to build a fighter jet or pay military personnel is a lot less than the equivalent in dollars that the US has to pay for the same goods and services. This means that China has a much bigger economy, if measured in China’s currency rather than in US dollars.
Many consider that PPP is the most accurate way of comparing economies with different currencies. It is the method used by the IMF and other reporting agencies. Even the US Commerce Department estimates that US GDP was $17.42 trillion in 2014, the same as reported by the IMF and others.
Yes, if you calculate China’s GDP in dollar terms only, without factoring in exchange rates, the US economy remains significantly larger than that of China. If measured in US dollars, China’s GDP is around $11 trillion. But such measures, although they are often quoted by the media and some reporting agencies, tell only part of the story. Why is that?
In order to answer this question, we have to look at foreign exchange ratios between the US and China. The official currency of the People’s Republic of China is the renminbi, often referred to as the yuan. The distinction between the terms “renminbi” and “yuan” is similar to that between British “sterling” and “pound,” which respectively refer to the British currency and its primary unit.
Currently, the foreign exchange rate between the renminbi and the US dollar is about 6.22 to 1, meaning that it takes 6.22 renminbi to purchase one US dollar. But the exchange rate masks an important point: 6.22 renminbi will buy you a lot more goods and/or services in China than one US dollar will buy you in America.
This is why Purchasing Power Parity is the more accurate measurement of GDP when comparing any two countries with different currencies and different costs of goods sold. And by that measure, the size of the Chinese economy exceeded the size of the US economy last year for the first time.
Should Americans Fear an Economic Crash in China?
With China’s economy growing at the slowest annual rate in almost 25 years, should that be alarming to Americans? Remember that China’s GDP is still growing at 7.4% a year as of 2014. While I believe there are things to worry about with regard to China, I don’t believe an imminent economic crash is one of them, as many in the media would have us believe.
But since this concern is prevalent today in the media, let’s discuss it. Clearly, on any list of calamities threatening the world economy, a China economic crash ranks near the top. But just what would constitute a “crash” is murky.
Already, China’s sizzling rate of growth has declined from above 10% annually – the average from the late 1970s until 2011 – to just above 7%, which is still high by historical standards. The question is whether the deceleration continues and growth goes much lower.
A faltering China could tip the world back into recession. China is a huge consumer of raw materials (grains, metals, fuels, etc.), so their prices would remain depressed if China enters a recession – not likely with GDP growth of 7.4% last year. Nevertheless, the media apparently believes we need to worry about it.
Likewise, if China fell into recession, it would increase its exports of basic industrial goods to make up for its sagging economy, which would also depress prices on the global market. This would dampen any recovery in global business investment. Global confidence would suffer.
Yet the real question is, despite all the media concern, is China really facing an economic crash what with GDP growth of 7.4% last year? I think the answer is no – that is unless we’re facing another global financial crisis.
Let’s look at some other numbers on the Chinese economy to put this into perspective. I’ll point to one in particular. In the US economy, consumer spending accounts for almost 70% of GDP; federal, state and local spending accounts for the other roughly 30%.
In China, by stark comparison, consumer spending accounted for only 37% of GDP in 2014. Let that number sink in for a moment. While consumer spending accounts for over two-thirds of US GDP, it accounts for just over one-third of China’s GDP. Government spending and private capital investment, for the most part, constitute the vast majority of investment in China.
Why is this important? China’s consumers will only increase their spending in the years to come, as a percent of the economy, as the country continues to westernize. With China’s consumer spending at only 37% of GDP, and destined to rise dramatically for the next several decades, it seems ridiculous to expect a crash in the Chinese economy in the next several years, although a short-term recession is never out of the question.
While China has no shortage of problems including a housing glut in some areas, soaring debt and overcapacity in several industries, the odds of the nation falling into a recession appear low at least for the next several years. The International Monetary Fund now predicts that China’s GDP will grow by 6.8% in 2015. As noted above, that means China’s GDP will very likely continue to exceed that of the US for years to come, as measured by purchasing power.
Still, we can’t forget the example of Japan. In the 1980s, it was temporarily regarded as the world’s most dynamic economy. But then, Japan’s prospects collapsed. New Asian competitors (Taiwan, South Korea, etc.) and an appreciating currency destroyed its economic model of export-led growth. Unable to build a new model, Japan has foundered ever since.
China is not likely at a similar juncture. However, while China’s economic future is optimistic, there is also consensus that its economic model is outmoded. Its export-led growth, high investment spending and low consumer spending model has to change going forward. The 2008-09 financial crisis showed the limits of China’s growth model.
Exports fell, as China’s biggest customers – the US and Europe – went into recession. To bolster its economy, China implemented a $586 billion stimulus package, almost 13% of GDP in 2008. But unlike the US stimulus in 2009, which was part of the federal budget, much of China’s extra spending was channeled through state-owned banks and local governments.
What ensued was a credit boom that has now left a large overhang of unsold housing, surplus industrial capacity and questionable debt. This on its face would seem really bad and would merit all the media concern. But the fact is, with China’s GDP made up of only 37% consumer spending – with room to double over coming decades – China’s GDP is likely to continue to dwarf the US for years to come.
Yet the point is, that’s not necessarily a bad thing. With its 1.36 billion people, China’s demand for western goods and services will continue to grow in the next several decades. As long as we remain competitive on the world stage, that should be good for America.
If you want to worry about China, worry about its military aggression (see article below), not its economy.
Gary D. Halbert
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