China’s #2…

Yesterday morning, the government in Tokyo announced its June quarter GDP totaled $1.28 trillion, slightly below Beijing’s previously announced $1.33 trillion for the same period.  By surging ahead of Japan, China has become the number two economy in size in the world, after the United States, relegating Japan to third place.

This was headline news in financial newspapers and websites around the world–except for the Wall Street Journal, which carried an article about criminals’ use of underwear with secret pockets in it on its website instead.

…at $5+ trillion of GDP

Annualizing China’s second quarter GDP would mean full-year economic value creation of $5.3 trillion, or a little more than a third of what the US will achieve in the coming 12 months.

Conventional measures undervalue developing countries’ economies

International economists have known for a long time that there’s something wrong with the conventional way of comparing GDPs between countries, however.  It isn’t just that the renminbi isn’t freely traded and might be, say, 15% against the dollar if it were–and that therefore Chinese GDP could be almost a trillion dollars higher than the amount reported.  Nor is it that the yen has shot up agains the dollar by about 10% over the past few months, making Japanese GDP a tenth higher than it would otherwise be.

Purchasing Power Parity GDP

The real issue is that the conventional comparison uses currency market exchange rates to convert GDPs into a standard form (US$).  This is a reasonable way to measure the relative value of sectors whose output is traded internationally.  But it’s not a very good method, especially when dealing with developing countries, to assess the value of economic output in non-traded parts of an economy.  You get a better measure of relative size of economies using purchasing power parity GDP, a topic I’ve written about in detail in another post.

Using purchasing power parity GDP, China had a $8.8 trillion economy in 2009 vs. $4.2 trillion for Japan.  In other words, China is already twice the size of Japan, surpassing the latter six or seven years ago.  The Middle Kingdom is not a third the size of the US, but almost two-thirds as big.  And, on the PPP GDP measure, China will surpass the US to become the largest economy on the globe around 2020, not 2030, as forecasters think China might do using the traditional GDP calculation technique.

the real story

What is the real story then?  It’s that the China GDP story is front page news.  To me, it means that US and Europe continue to underestimate the size of the developing economies, and of China in particular.

Both the IMF and the CIA do purchasing power parity calculations, and come up with almost precisely the same results.  According to both, total world GDP last year was about $70 trillion.  The largest economic entities were:

BRIC countries     $16.4 trillion     (23.4% of the world)

EU          $15.0 trillion      (21.4%)

US     $14.3 trillion     (20.4%)

The Eurozone, that is, countries actually using the €, had GDP of $11 trillion (15.7%) last year.  As mentioned above, China had GDP of $8.8 (12.6%) trillion.  NAFTA had GDP of $17 trillion (24.3%).

conclusion for investors

Looked at from the PPP perspective, the world consists of three large economic blocs, all of about equal size:  NAFTA, BRICS and the EU, in that order.  The BRICs, by far the fastest-growing of the three groups, will probably pass NAFTA this year.

Why is this important?

Investors should realize that the MSCI World Index is constructed using the following approximate country weightings:

US + Canada    45%

EU     26%

Japan     8%

Australia, Korea, Taiwan     7.5%

the rest     12.5%.

That looks an awful lot like the conventional-GDP view of the world.  You get a heavy dose of the US, EU and Japan with the traditional indices, but very little of the really fast-growing 25% of the world.

The EAFE index, the standard international index for Americans, is even more skewed than the MSCI World.  Its country weightings:

Europe ex UK     42%

UK     21%

Japan      23%

Australia  9%

everything else     5%.

Again, a heavy dose of the most mature markets, with little else.

What I’ve just written is substantially correct, but a few caveats are in order.

–Most stock markets in developed countries have a healthy number of multinationals, which have established beachheads in the developing world to benefit from the growth opportunities they offer.  So the skewing away from the developing world is not so severe as the country allocation suggests.

–Some developing markets aren’t open to foreigners, mostly out of legitimate concern that their developed market cousins will buy the nations most prized assets on the cheap–which of course is what we’re trying to do.

–Some developing markets can be highly illiquid, as well as requiring a large amount of local “street smarts” for you to be an active stock picker in.

where to get developing markets’ exposure

There are specialized mutual funds with good track records, like the Matthews China Fund, or ETFs, that can give you the exposure you might want.  Remember, though, that these are higher than average risk/reward investments, so be sure you’re willing/able to assume the greater chance of loss.