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DATE IMPORTED:March 24, 2014U.S. President Barack Obama (R) meets China's President Xi Jinping, on the sidelines of a nuclear security summit, in The Hague March 24 2014. Obama began crisis talks with his European allies on Monday after Ukraine announced the evacuation of its troops from Crimea, effectively yielding the region to Russian forces which stormed one of Kiev's last bases there. Obama, who has imposed tougher sanctions on Moscow than European leaders over its seizure of the Black Sea peninsula, will seek support for his firm line at a meeting with other leaders of the G7 - a group of industrialised nations that excludes Russia, which joined in 1998 to form the G8. REUTERS/Kevin Lamarque
Reuters/Kevin Lamarque
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DOES SIZE MATTER?

Here’s what’s really scary about China overtaking America as the world’s biggest economy

By Gwynn Guilford

This post has been updated.

The twilight of America has sneaked up on us, proclaims MarketWatch. “For the first time since Ulysses S. Grant was president, America is not the leading economic power on the planet,” MarketWatch darkly rasps. In case you haven’t guessed which country’s taking the lead

A screenshot from the Drudge Report, one of the biggest American news aggregators.

This is indeed a scary reminder of a shifting world order. But probably not for the reasons implied. The real worry isn’t that China’s landed the top ranking, but how it’s done that—and the long, painful, Japan-style stagnation that likely awaits it as a result.

But first, some context. At some point China’s economy will definitely surpass that of the US–and it’s baffling why this spells doom to America. China has more than four times as many people as the US does. It should be bigger.

But that hasn’t happened yet. We’ve cracked this chestnut before: basically, the IMF just recalculated its projection of China’s 2014 GDP using an updated revision to purchasing-power parity adjustments, which is supposed to more accurately reflect buying power. Since living costs are cheaper in China than they are in the US, the adjustments inflate China’s GDP.

This is ultimately an apples and oranges comparison though, as Michael Pettis, finance professor at Peking University, explains here. American GDP reflects losses; China’s, for the most part, doesn’t. How you adjust for cost of living matters little given that so much of China’s mammoth GDP has been funded by credit, little of which has been paid back. Its account data treats the money spent building a factory, say, or a luxury suburban high-rise as value created—even if those projects never bring in the money to pay back those loans.

That’s not saying China has more debt than the US, which had racked up $59.4 trillion as of the second quarter. But the US counts the debt unpaid against its GDP; China, because its financial system is underpinned by the assumption that nearly all debt will be paid by the government, mostly doesn’t.

No one really knows how big those losses actually are. However, this should give you a sense: two Chinese government researchers recently estimated that in the last five years, China has invested $6.8 trillion in worthless projects (paywall), based on the current exchange rate. In 2013 alone, China blew 13.2 trillion yuan ($2.1 trillion). Assuming it reined things in a bit and frittered away the same amount this year, China’s PPP-adjusted 2014 GDP would be something like $14 trillion—a ways off from the $17.4 trillion the US is supposed to reach. (Note: here’s The Economist‘s argument against their calculations.)

Eventually, someone has to pay for all this stuff. Chinese banks might, if the government allowed defaults to start happening.

But that would be highly disruptive. More likely, the Chinese government will go the route Japan took over the last two-plus decades, gradually absorbing the price of that waste onto its own balance sheet. Without widespread failures of wasteful state companies, a vibrant private sector will struggle to emerge—even though that’s exactly what China needs to see its GDP (the accurate one) reach new heights. This zombie invasion will have truly terrifying prospects for China’s long-term growth. But for a while at least, the official data will probably keep looking just as Drudge-style scary as it does to some people today.

Updated Dec. 7, 2014 (10:30am EST): This post has been updated to include a link to The Economist‘s takedown of Xu Ce and Wang Yuan’s calculations, and now includes a link to the Financial Times‘ story about their findings.