Why Reports of China's Economy Overtaking the US Are Very Wrong

In the space of 24 hours, reports have claimed that the US economy will be overtaken by China in the imminent future.

In tandem, the world's currently largest economy revealed it has returned its lowest GDP quarterly growth level in more than two years.

Rather than burying the bad news, they decided to unleash it all at once. Except it isn't all doom and gloom- as the headlines imply.

The GDP slump is an aberration, rather than an indicator of a wider trend.

And analysts agree that the suggestion that China is to usurp the US as the global financial superpower is extremely misleading.

Research from the International Comparison Programme, a division of the World Bank, said that China's purchasing power parity (PPP) is 20% higher than previously thought.

Purchasing power parity is a technique used to determine the relative value of different currencies. The fact that China's is so much higher than anticipated led the ICP to predict that China's GDP will overtake that of the US this year.

But economists warn that such sweeping generalisations are unhelpful and, usually, wrong.

Julian Jessop, chief global economist at research firm Capital Economics, said: "The significance of revised PPP is not as great as some of the headlines imply. For a start, GDP in isolation is a poor measure of relative importance in the global economy, let alone in financial markets.

"To the extent that GDP is useful as a measure of economic power, comparisons using actual market exchange rates may be more meaningful. On this basis, it will probably be at least another 10 years before China 'overtakes' the US as the world's largest economy."

The methodology used by the ICP is suited to academic purposes and is only partially relevant to real world activity. PPP does not consider real-world currency exchange rates, which of course determine international purchasing power.

The Point of PPP

PPP, then is more a measure of a nation's domestic purchasing capability, and in poorer countries the local currency will naturally go further. The yuan may well be capable of buying more goods in China, but it would flounder when pitted against the dollar in America.

According to Jessop: "On the basis of actual exchange rates, China's economy is still not much more than half the size of the US. On the basis of actual exchange rates, China's economy is still not much more than half the size of the US."

Best guesses as to when the crossover of market exchange rates will take place range from sometime between 2025 and 2030.

But the debate also exposes a wider issue: the fallacy of GDP evangelism. GDP is an excellent tool if one is measuring a country's economic activity, but it's not necessarily a good indicator of economic or general well-being.

For instance, the Deepwater Horizon oil spill in the Gulf of Mexico actually added to the GDP growth of the US in 2010, according to JP Morgan. The moratorium on drilling and commercial fishing in the Gulf led to job losses and less productivity. But the clean-up effort, which put 4,000 people to work and cost up to $6bn outweighs those negatives.

But can anybody argue with a straight face that the spill was a positive event for the US economy?

China vs US

Equally, while China may be catching the US in terms of GDP, there are other indicators in which it lags way behind.

The infant mortality rate in China between 2009 and 2013 was double that of the US. Some 99% of US citizens aged 15 or over are literate in the US, compared with 95% in China. Living standards in many Chinese cities remain well behind the US.

In terms of growth, the US is expected to recover strongly over the rest of the year. In quarter two, growth of 3% is predicted, which is in line with longer-term economic aspirations.

Yesterday's slump has been largely blamed on the weather, with the US having experienced one of the coldest winters on record. Equipment purchases and residential construction were hit particularly badly by the cold snap.

So while China is gaining on the US in terms of pure output, it has a long way to go. Reports of a US decline have been greatly exaggerated.