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Category Archives: Purchasing power parity (PPP)
China’s GDP bigger than Japan’s: that’s not the real story
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.
What are Purchasing Power Parity (PPP) and Purchasing Power Parity GDP?
Purchasing Power Parity (PPP) is a name that covers a number of loosely related ideas. The most important, I think, are:
–PPP as a theory of predicting long-term exchange rate equilibria, and
–the calculation and comparison of country GDPs using PPP.
In the first sense, PPP answers the question of what exchange rate would prevail in an ideal world where workers in different countries all have equal compensation. In the second, PPP says what country GDPs should really be if the value of non-traded goods were factored into the calculation–not just traded goods.
PPP and currency values
PPP is a labor theory of value. The basic idea is that the average worker, no matter what country he works in, should earn enough money to buy stuff that will give him the same standard of living as a worker in any other part of the world. This is the equilibrium condition. If, at any given time, this condition does not hold, currency exchange rates will realign themselves so that equilibrium is established.
I first encountered PPP as a practical thing when it came into vogue in the mid-Eighties, a period of great instability in exchange rates. It was for a while the preferred method of currency forecasting. It didn’t work very well, however. Apart from the more general question of whether value of a good in trade is determined by the amount of labor expended in its making, there were three practical issues:
1. tastes may differ from culture to culture, so determining “equal” baskets of goods and services across countries isn’t as easy at it sounds,
2. in the real world, prices subject to local cartels or government regulation may change only very slowly, and
3. other factors, like the emergence of substitutes or a significant change in the price level (think: Japanese deflation in the Nineties) can do the work ascribed in this theory to currency movements.
Purchasing Power Parity GDP
GDP calculated under PPP is a different matter. The issue first arose, I think, in connection with the rapid growth of the mainland Chinese economy during the Eighties, when it averaged double-digit annual expansion of real GDP. This compares with the US, which averaged, say, 3%. Whatever imprecision there may have been in the actual numbers reported by the two countries, it was clear that China had grown much, much faster than the US during the decade.
The conventional way to compare countries’ GDP is to take the local currency number for each economy and translate the result into come reference currency, typically the US$. The common sense result guess for the Eighties would have been that China had doubled in size relative to the US during the decade. But when the conventional calculations were done, China had actually shrunk in relation to the US.
The problem?–the conventional calculation uses market exchange rates, which express the relative price relationships among traded goods, like cars, and uses that relationship as a proxy for the value of all goods in an economy. That doesn’t work well. In an emerging economy, a haircut, a bus ride, even cellphone service will typically be much cheaper than in a developed economy.
Seeing the US/China result was enough to prompt the World Bank to attempt to make GDP calculations that included non-traded goods as well. These are the 2008 World Bank figures. The results are startling, though less so than they would have been two or three years ago, when Brazil, India and Russia would have had their approximate PPP rankings but would have been out of the top ten in the conventional ones:
—————–rank % of world GDP —– rank % of PPP GDP
US 1 23.4% 1 20.3%
Japan 2 8.1% 3 6.2%
China 3 7.1% 2 14.3%
Germany 4 6.0% 5 4.2%
France 5 4.6% 8 3.0%
UK 6 4.3% 7 3.0%
Italy 7 3.8% 10 2.6%
Brazil 8 2.6% 9 2.9%
Russia 9 2.6% 6 3.3%
Spain 10 2.6% 12 2.0%
Canada 11 2.3% 14 1.7%
India 12 2.0% 4 4.9%
Mexico 13 1.8% 11 2.2%
Note that China and India are together about the same size as the US as a percent of world GDP when measured by PPP, vs. less than 40% of the US when measured conventionally.