Pearls and Irritations

Although rarely acknowledged, China is the world’s biggest economy, and it will most probably continue to grow faster than the US, its main competitor.

A core American belief is that America is exceptional. A belief that is underpinned by the presumption that the US is the most powerful country in the world, both economically and militarily.

As the US spends more money on defence than the next ten countries combined it is safe to assume that the US is the world’s most powerful country militarily. Although because US forces are spread around the globe, arguably the US does not have the most powerful military capability in East Asia, where China’s forces are concentrated.

Which is the biggest economy?

On the other hand, using the only measure that should count, China is definitely now the biggest economy in the world even though the media consistently report that China is still the second biggest economy in the world.

The reason why China is thought to remain in second place is based on a comparison using exchange rates to value the two countries’ GDP on a common basis.

However, as all statisticians know exchange rates can be over or under valued in terms of their purchasing power. That is why The Economist magazine each year produces an alternative measure of different currencies purchasing power by comparing the price of a MacDonald’s hamburger in different countries, noting that a Big Mac is exactly the same wherever you buy it.

So instead of using exchange rates as the basis for comparing the US and China’s GDP, we should revalue all the individual goods and services that China produces using the prices that would be paid for them in America. That way we compare the two countries’ GDP in terms of what is technically called their purchasing power parity.

Thus, according to the IMF, valued in terms of their purchasing power parity China’s GDP in 2023 was 32,931 billion international dollars compared to the US GDP of 27,358 billion international dollars. In other words, the latest data show that China’s economy is twenty per cent bigger than America’s.

But that begs the question as to why the US dollar is so over-valued compared to the Chines renminbi, and thus gives a misleading impression as to which is the biggest economy. The answer lies in some key differences in the fundamentals of the two economies.

A comparison of Chinese and American saving behaviour

What really stands out when comparing the fundamentals of the Chinese and American economies is the difference in their respective saving behaviour.

In brief, for the last ten years, Chinese national savings have ranged between an incredibly high 43 to 47 per cent of China’s GDP. By comparison US national savings are substantially below other developed countries, such as Germany or Japan (both around 29 per cent of GDP), and less than half Chinese savings rates, with the US national savings rate ranging between just under 20 and 16 per cent of GDP over the last decade.

The counterpart of China’s exceptionally high savings rate is that household consumption is very low – around 37% of GDP, compared to 60% or more in most advanced economies. On the other hand, the Chinese investment rate is very high, typically over 40% of GDP or 1 to 1½% less than the savings rate.

That high investment rate is an obvious reason why China’s rate of economic growth has so far exceeded the US growth rate that China has been able to catch up and is now the bigger economy. But the low rate of Chinese consumption would never have sustained this high investment rate on its own. Instead, China has had to depend upon a high rate of foreign demand for its exports to foreign markets to sustain the increase in aggregate demand needed to maintain Chinese employment.

In effect, the Chinese growth model has relied upon foreign demand partly financed by capital outflows, including through the Belt and Road initiative, to support demand for Chinese goods and services, and sometimes by directly employing Chinese labour as well.

But the fact that Chinese national savings are high relative to aggerate domestic demand means that the cost of borrowing in China (interest rates) are typically significantly lower than in America. For example, right now the yield on a 10-year Chinese government bond is 2.3% compared to 4.5% on the US government equivalent.

That difference in interest rates helps pull the American dollar up and pushes down the Chinese renminbi. As a result, Chinese goods and service seem cheaper than American when valued in dollars, and this difference provides a substantial competitive advantage for China.

The future economic outlook

Clearly China’s economy has outperformed America’s over the last forty years. But that was to be expected as China was catching up. Now, however, some American scholars are saying that Chinese growth has peaked, and that it will not present such a threat to America in future. Even President Biden said in August 2023 that “China is a ticking time bomb” that “doesn’t have the same capacity as before.”

Key factors underpinning this conclusion that China is past its prime are:

First, China’s workforce has started to decline and is projected to shrink by 20% by 2050.

Second, a major use of Chinese high savings was to finance a property boom, which led to massive over-development with far too many empty dwellings. As was to be expected, that property boom has now busted, leaving many developers, including local government authorities in the lurch.

However, this month the Chinese government responded by announcing that it will raise loans to tap the excessive private savings, and these loans will be used to stabilise the property sector by buying out the unused properties. There is no doubt that with China’s excessive savings the Chinese government can readily raise the money for this form of intervention.

Third, the global system of free trade under which China got rich is now disintegrating. Since 2017, the US has led the way in seeking to constrain Chinese competition by increasing tariffs on Chinese exports and in various other ways America has sought to limit Chinese growth.

Nevertheless, the Chinese share of world export has continued to increase and its trade surplus of around $823 billion in 2023 was nearly double what it was in 2017. The problem is that since then the US inflation rate has been higher than China’s and consequently the US dollar should have depreciated against the Chinese renminbi. However, assisted by large Chinese capital outflows, the dollar appreciated instead so that it is now estimated to be around 21% overvalued.

Most recently, President Biden decided to respond by imposing further tariff increases, including tariffs of 100% on electric vehicles made in China, and Europe is also now contemplating restrictions to limit Chinese competition. These restrictions by the US and its allies are a denial of the global rules-based order that America originally tried to create.

Nevertheless, the typical justification for these measures is that China steals other countries’ ideas and subsidises its exports. But it is an open question how much difference these tariff increases will make, other than damaging the living standards of Americans and Europeans, as well as international relations.

The reality is that China is a world leader (see more below) in the industries of tomorrow, aided by a significantly undervalued renminbi, a result of high capital outflows caused by both China’s response to its high savings and the US restrictions on investments in China.

Fourth, it is alleged that the authoritarian system of government reintroduced by President Xi Jinping will stultify Chinese entrepreneurs and thus Chinese innovation. But the fact is that China is dominating the industries of tomorrow.

Under Xi Jinping’s leadership China is deliberately focussing on the production of electric cars, batteries, solar panels, critical minerals and bio-manufacturing. And in many cases it is already a world leader, not depending on foreign technology at all. For example, even The Economist, which is usually critical of China, last week wrote that “The real fear about Chinese EVs is not that they are stealing from America, but that they have left American cars in the dust.”

It was, of course, always to be expected that as the Chinese economy matured, it would experience some reduction in its rate of economic growth, compared to the average annual growth rates of 9.3 and 10.4 in the 1980s and 1990s respectively when China first started its reforms and industrialising.

Nevertheless, in the last decade from 2013 to 2023, although China’s annual GDP growth rate fell back to an average 6.0 per cent it was still much higher than the American average of 2.3 per cent. And most recently, last year in 2023, the Chinese economy grew by 4¾ per cent, nearly double the growth rate for the American economy of 2½ per cent.

Looking to the future, the biggest risk to the Chinese economy remains its very high savings rate, especially if it must rely less on foreign demand in future to ensure that aggregate demand is sufficient to sustain full employment. But even on a worst-case scenario, if China can no longer rely as much on foreign demand to balance its high savings rate the solution lies in its own hands.

The obvious reason for China’s high savings rate is that there is little government provision of support for people who need it. Instead, people are forced to save to provide for their retirement or if they are sick or otherwise unable to work. Thus, it is probable that if China became much more of a welfare state, as would be consistent with its socialist ideals, the savings rate would come down and China could then rely less on foreign demand, while its people would be better off.

In sum, the idea that China will stop growing faster than the rest of the world, and that America will maintain its economic dominance is clutching at straws.