Back in April, the World Bank shocked the world when it revealed that, based on the real cost of living, China’s economy will surpass the US to close out 2014 as the world’s biggest. The alarm came from the fact that economists expect China to seize the crown only in 2019 or thereabouts.
Well, cue the hand-wringing: It’s official. The IMF just updated the cost-of-living adjustment basis that it uses to forecast 2014 GDP (itself created by the World Bank). The new calculation shows China’s economy will total $17.6 trillion, a hair more than the US’s $17.4 trillion, reports FT Alphaville (registration required).
According to the Financial Times (paywall), this information should “revolutionize the picture of the world’s economic landscape” and “intensify arguments about control over global international organizations such as the World Bank and IMF.”
But that’s getting a little ahead of ourselves—especially since China overestimates its GDP.
First let’s get into what the World Bank’s “purchasing power parity” (PPP) adjustments are designed to do. Say one person makes $50,000 a year in New York, and another the same amount—307,000 yuan—a year in Chengdu.
On the face of it, they earn the same. But because food, housing, and so on is much cheaper in Chengdu than in New York, the guy in China can buy the same amount of stuff that a New Yorker with a salary of, say, $80,000 could afford.
That’s why the World Bank’s “purchasing power parity” (PPP) adjustments taking local prices into account—to even out that discrepancy, and up the Chengdu resident’s salary for international comparison purposes to $80,000. On an enormous scale, that’s basically just what happened in the IMF’s calculation: It tells us that China’s GDP will buy its people more shoes or cabbages or whatever than America’s GDP will buy Americans.
But there’s one huge flaw in that logic. The problem isn’t in the adjustment itself, but rather the base data—i.e. how differently China and and the US calculate GDP, says Michael Pettis, a finance professor at Peking University.
Say a business borrows $100 and invests it in a new factory. The factory, however, only creates $80 in value, leaving the company short $20. In the US, either the business sells an asset to pay back the loan or shifts profits from another division, or it defaults, leaving the bank to write down the $20.
But Pettis suspects that since the number and value of defaults in China are far less than those in the US, China isn’t recognizing this bad debt in the same way.
This isn’t necessarily some Communist Party subterfuge. It happens because “Chinese lenders, banks as well as households, treat a substantial portion of the debt as if it were implicitly or explicitly guaranteed by central or local government agencies,” writes Pettis.
So instead of writing down the loss or making the business cough up that $20, a Chinese bank will defer the debt payment—called “rolling over” the loan—to the Chinese company (or in the case of non-state-owned firms, the company might take out another loan via shadow channels, which aren’t recorded on bank balance sheets). That means that not only does the $20 loss never show up in China’s GDP calculations; but the $80 that the factory created does get counted. And presto—$100 of GDP points that really aren’t there.