How Big is China?

China-bashing is back in fashion in Washington and Brussels.  The U.S. Congress is demanding that China re-value its currency to correct what is perceived as a trade imbalance.  The financial press has called this, delightfully, a product of “The collective brain deficit trust, otherwise known as the US Congress.” Europe is also growing increasingly impatient with the Chinese propensity to undervalue its currency – and more broadly with the Asian tendency to do the same.  With massive imbalances in the English-speaking world, and Asian currencies effectively pegged, the euro has been left to pick up the slack.  Logically, this leaves exporters in Europe unhappy. The U.S. current account problem is not, of course, China’s fault.  The Bush Administration, aided and abetted by local governments and private households, has been fiscally profligate.  Combined with dismally low savings rates, this means the U.S. ran a current account deficit of 6.5 percent of national income, according to the IMF, in 2005 and 2006. Thankfully, this is projected to fall to “only” a deficit of only 6.1 percent in 2007.

China’s exchange rate policy mirrors, in some ways, the growth path followed by German from 1947 through 1970.  Germany built its economic miracle on a strong export industry supported by an undervalued D-mark and by the recycling of its surplus through foreign investment and aid.  (See Hetzel for more on this.)

So… if China is following a path marked by Germany, what exactly is the problem? To put it bluntly, the problem is the dragon in the middle of the room.  China’s economy has grown, to be hyperbolic, to epic proportions.  Before I discuss numbers, I should briefly review the concept of purchasing power parity and the Balassa-Samuelson effect.  Because wages are low, service prices tend to be low in developing countries.  This translates into a general low price for non-traded goods, so that official exchange rates understate the actual value (and hence size) of the domestic side of developing economies.  Various efforts are made to adjust for this (i.e. to make values reflect relative prices) when we compare per-capita incomes.  This means that the size of China’s economy is underestimated when we use world prices.  This is even before we add the issue of an undervalued exchange rate.  This point is illustrated in the figure below.





In the figure, the left-hand axis plots China’s GDP, while the right-hand axis plots China’s current account surplus as a percent of GDP.  The first set of numbers is at nominal prices, and the second reflects adjustment of China’s GDP to reflect differences in prices and purchasing power (known as a PPP adjustment).  What emerges is that while China’s trade surplus, as a share of GDP, is huge at official exchange rates, it is actually quite reasonable given the actual size of the Chinese economy.  Indeed, if we valued the basket of China’s domestic (i.e. non-traded) goods and services at U.S. prices, the Chinese economy is roughly 81% the size of the U.S. economy, while the trade surplus is only 2.7 percent, rather than the 10.0 percent estimated by the IMF at official exchange rates.  A consequence of China’s current exchange rate policy is to overstates its trade surplus, and understate the size of the underlying domestic economy. Indeed across Asia we tend to understate the size of the regional economies and overstate trade relative to domestic activity for the same reason. You can make these, and similar calculations, yourself with data from the IMF's World Economic Outlook.

In the interest of overkill and overstatement, the second figure compares Germany, China, and the U.S. in 1980 and 2007.  Again, we are looking at GDP and the current account surplus, adjusted for PPP.  What this shows is that, valued at OECD prices, China’s economy has surged past Germany, and is now over 4 times as big as Germany’s.  This contrasts sharply with unadjusted data. At official exchange rates and without adjusting for China’s price levels, the two economies are roughly the same size.  Also striking is the size of the relative trade surpluses.  The IMF projects that Germany will have a current account surplus of 5.3 percent (at official exchange rates), which is equal to 6.1 percent of PPP-adjusted GDP.  China’s trade surplus, on the same basis, is 2.1 percent of PPP-adjusted GDP.  In terms of the share of goods and services produced and priced on the same basis, Germany’s current account surplus is 3 times larger than China’s on a share basis.  Yet Congress is not bashing the euro zone.  Congressional moves attacking currency manipulators (i.e. Baucus-Grassley-Schumer-Graham)  target Asia, not Europe.

Given the relative under- and over-valuation of Asian and European currencies, and the relative size of current accounts relative to actual GDP, one is left a bit bemused.  China is following a macroeconomic growth path marked out by Germany, and for this it is being condemned.  At the same time, U.S. imbalances are being pegged on everybody but the U.S. itself.  And no one is talking about the real reason why China’s surpluses have such a big impact on the world economy.  Quite simply – China has grown huge, and this is masked by current exchange rate policy, combined with a healthy does of Balassa-Samuelson effects.  For a long time, as the world’s biggest kid on the block, U.S. imbalances have had a major impact on global capital markets, sometimes sucking capital in from smaller countries and regions.  China (abetted by Japan) appears to be softening this effect somewhat.  Do we really want this to end abruptly? Be careful what you wish for, as you may actually get it.

Further reading

[1] Be careful what you wish for,” John Mauldin, FXstreet.com, 16 June 2007.

[2] German Monetary History in the Second Half of the Twentieth Century: From the Deutsche Mark to the Euro,” R.L. Hetzel, Federal Reserve Bank of Richmond Economic Quarterly Volume 88/2 Spring 2002: 29-64.

[3] Baucus-Grassley-Schumer-Graham,” International Political Economy Zone:  Tales of Power, Money, and Occasional Violence, Wednesday June 13 2007.

[4] Balassa-Samuelson Effect," Wikipedia.

[5] The IMF's World Economic Outlook database.

[6] The International Comparison Program.

[7] " France Raises Prospect of New Bra Wars," The Scotsman, 19 Jun 2007.