Saturday, July 03, 2010

When Will China's Economy Become Bigger Than America's?

I have long argued that it is more or less inevitable that China's economy will in a not too distant future become the biggest in the world.

I am more convinced than ever of the truth of this prediction. Each year it seems, China passes at least one new milestone. In 2008, it surpassed Germany to become the third biggest economy. In 2009, it surpassed Germany as the biggest exporter and America as the biggest car market. In 2010, it will (barring a really dramatic yen appreciation) surpass Japan as the second biggest economy.

But exactly when will China surpass America as the world's biggest economy? Obviously, we can't for sure pinpoint the exact year it will definitely happen. But we can pinpoint using basic arithmetic just when it is likely to happen.

And the numbers clearly suggests that old estimates that the shift won't happen until 2040 or 2050 are far off the mark.

In 2009, nominal GDP in America was according to preliminary estimates, $14.26 trillion. In China, nominal GDP was 34.05 trillion yuan, or $4.98 trillion using the average 2009 exchange rate. That means that America's GDP was 2.86 times bigger.

With average annual growth in America being some 7.5 percentage points lower during the 2000s, then assuming that this will continue and that the real exchange rate of the yuan will appreciate by on average 3% per year (quite reasonable, given the reality of the Penn/Balassa-Samuelsson effect and the strong pressure on China to make its currency stronger), then it will only take 11 years before the Chinese economy becomes bigger, meaning that by 2020, China's economy will be the biggest in the world.

If we assume that the growth differential falls to just 5%, while the estimated real appreciation is assumed to be just 2.5% per year, then China's economy will become bigger by 2024.

In order for the old estimate of 2040 to hold true, then we would have to assume a ridicuosly low total growth differential and real appreciation of just 3.5% per year.

Given the falling returns from the "catch-up effect" that naturally follows when a nation becomes richer, it is unreasonable to assume that the growth differential of the last decade will last forever, or even for several more decades. But since per capita income would still be much lower in China when its economy are as big as America given it's much bigger population, it is quite reasonable to expect a similar growth differential for a while, and to expect a significant real appreciation of the yuan, making it likely that the year when China will become biggest somewhere between 2020 and 2025.