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China might NEVER become the biggest economy in the world

It is often assumed that given China’s remarkable growth rates over the past three decades – around 10% real GDP per year – China is on the way to soon becoming the largest economy in the world. In fact earlier this year it got a lot of media attention that when the World Bank argued that China already had overtaken the US as the largest in economy in the world. However, the argument was completely bogus as it was based on Purchasing Power Parity (PPP) rather than on actual exchange rates (To be fair we should blame the media rather than the World Bank for this interpretation of the data).

PPP based measures of GDP (per capita) might make sense if we want to measure how much an average citizen can buy for given an average income, however, it does not make sense when we want to measure the size of the economy. There we have to use measures based on actual exchange rates and if we do that then it turns out that the Chinese economy is still significantly smaller than the US economy. Hence, total Chinese GDP today is around 10 trillion USD, while US GDP is around bn 17-18 trillion USD. Said in another way the US economy is still nearly double the size of the Chinese economy.

And what I will argue in this post is that China might never overtake the US as the biggest economy in the world.

Chinese growth set to slow dramatically in the coming decades

There is a broad consensus among long-term macroeconomic forecasters that the Chinese economy is likely to slow significantly in the coming quarters – starting today!

There are overall three reasons why this is the case:

1) The catching-up process means less and less: A very large part of China fantastic growth performance over the past three decades is due to a “natural” catching up process. When poor economies – like the Chinese economy three decades ago – is freed up a catching up process is started. This means a lot for low-income economies, but as income levels increase the catching up process slows down. This is already the case for China.

2) Investment growth is likely to slow significantly: Fixed investments as share of GDP in China is extremely high – well above 40% of GDP. This is at least 10-15 %-point more than in other countries with a similar GDP/capita level. This to some extent reflect capital misallocation in the Chinese economy as investment decision in the Chinese economy to a large extent still is a result of quasi-central planing. It is therefore natural to expect investment growth to slow quite significantly in the coming decades.

3) China is facing serious demographic challenges: You can blame the Communist Party’s one-child policy or come up with other explanations but the fact is that the Chinese labour force is now already in decline and the decline will continue in the coming decades and soon the Chinese population will be in outright decline.

So from a growth-accounting perspective we have it all – less Total Factor Productivity growth – as the catch-up process slows, a slower increase in the capital stock and finally a declining labour force.

It is therefore hardly surprising that most long-term forecasts made for the Chinese economy forecast a rather significant slowdown in Chinese growth in the coming decades (See for example here.)

Closing in on the US, but China might never make it

It is commonly argued that trend growth presently is around 7-7.5% in China, however, it is equally common to argue that we will see a slowdown in real GDP growth to an average of around 5-6% in the coming 10-15 years. But the real slowdown comes after 2030 where the Chinese economy is expected by most long-term forecasters to start to approaching Japanese style growth rates and outright negative trend-growth should not be ruled out in the 2050s based on reasonable expectations about demographics, the investment ratio and the catching-up process.

Obviously it is difficult to make any macroeconomic forecasts. However, I would actually argue that it in many ways it is easier to make forecast 10-20 years ahead than 1-2 years ahead. When we do short-term forecast the shocks will always mess up our forecasts, but over a 10-20 years horizon the positive and negative shocks tend to even out. Furthermore, in the long-run it is all about supply side factors and with the growth rate of the labour force being a major factor we already know quite a bit. Hence, we have a pretty good idea about the growth of the Chinese labour force in 15-20 years as the people entering the labour force as young adults in 15 or 20 years already have been born.

I have gone through a number of studies of the long-term growth perspectives for the Chinese economy and based on that we can make a simple “simulation” of how the level of Chinese real GDP will develop from now and until 2060. I should stress it is not a forecast as such and lets therefore just stick with the term “simulation” of future Chinese real GDP under reasonable assumptions about the development in technology and in productions factors.

The graph below illustrates my argument that China might never overtake the US as the largest economy in the world. Here is my assumptions (and they can certainly debated, but they are not much different from the “consensus” forecasts for long-term growth in China and the US). I assume that trend real GDP growth in China over the next 15 years will be 6% – slowing from presently 7.5% to 4.5% in 2030. Hereafter the negative demographics in China really kick in and as a result trend growth drops to an average of just 2% for the period 2030-2060.

I have indexed Chinese real GDP at 55 in 2014 – reflecting that Chinese GDP (in USD) is around 55% of US GDP. In my simulation I have assumed that US trend real GDP growth is 3%. This is probably slightly optimistic compared to the “consensus” among long-term forecasters, but it is basically the growth rate we rather consistently have seen in the US economy since the early 1960s. The American demographic challenges are somewhat smaller than is the case for China and I find it rather likely that the US gradually will adjust immigration policies so meet these challenges (I certainly hope so…)

It is important to stress that I here assume that the there is no real appreciation or depreciation in the USD/RMB exchange rate (no Balassa-Samuelson effect). Hence, the exchange rate development is determined by relative inflation in the US and China. This might twist the results slightly against China. On the other hand I have also assumed that the output gap is zero in both countries. In fact the output gap in the US is still negative, while the output gap in China likely is close to zero or even positive. This twists the results against the US. Lets just (completely unreasonably) say that these factors even out each other.

China will NEVER catch up

So there you go. You see under these – simplistic – assumptions the Chinese economy will continue to gain on the US economy over the next two decades. However, under these assumptions (and I again stress it is assumptions) it will be close (around 90%), but no cigar for the Chinese economy – the Chinese economy will never be the largest economy in the world – or at least not in my life time and I do plan to live to at least 2060.

Furthermore, starting around 2040 China will stop catching up and instead see its economy decline relative to the US and in 2060 we will be more or less back where we started with Chinese GDP being around 60% of US GDP.

Now you might say that these results are too negative in terms of China or too positive in terms of the US and that might very well be the case. However, I do think that my simulations illustrate that China is not automatically set for global economic and financial domination. So while China – for a period – might become a bigger economy than the US – if we for example assumption 2.5% US trend growth rather than 3% – the negative demographics will start to kick in soon and that will ensure that the US economy will remain the biggest economy in the world – also in 50 years. This also means that it is quite hard to imagine in my view that the “financial centre” of the world will move to China and I find it extremely hard to imagine that the Chinese renminbi will take over of the role as the leading reserve currency of the world from the US dollar.

But there is no reason to cry for the Chinese

So China might never become the biggest economy in the world. However, that should really not be important for the Chinese. It might be for Chinese policy makers, but the average Chinese should instead celebrate the fact that outlook for his/her income level remains very bright and income growth for the individual Chinese is likely to remain very high in the coming decades. So the discussion above should not really be seen as being “bearish” on China. In fact I am rather optimistic about the Chinese “miracle” continuing in the coming decades. We should celebrate that, but we might never be able to celebrate the day the Chinese economy overtakes the US in absolute size.

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16 Comments

  1. China needs to get rich before it gets old. It doesn’t have a lot of time!

    Reply
  2. I agree with the basic argument. China undoubtedly faces a demographic challenge. While it may seem unlikely today, what if the Chinese government is recruiting immigrants 10 or 15 years from now?

    Reply
  3. Lars,
    It was my understanding that the process of transforming unproductive peasants in the west into productive factory workers in the east has an inventory of peasants that is almost inexhaustible. This was a big part of the logic that worker productivity can continue to rise for decades to come. I’m sure that there are diminishing returns and huge negative externalities, but the underlying logic seems to be intact. Indeed, there is the possibility that the west itself can be industrialized. I see China as a mortal threat to global manufacturing, and hence I support anti-mercantilist policies.

    Reply
  4. TIMBUDONG

     /  August 28, 2014

    LOL no. Just no. We build for CHINA. I for one welcome our Chinese overlords.

    Reply
  5. Your analysis has the following issues:
    1) With time any modern economy achieves more or less, the same GDP/capita.
    This is already the case today: The US has only a bit higher GDP/capita compared to Germany, UK or Japan and less than the double of Italy.

    2) Once this high level of GDP/capita is achieved, GDP growth is mostly driven by population growth and technology, some might call this status secular stagnation or “consumption-driven” growth like I do:
    http://snbchf.com/global-macro/consumption-driven-economies/

    3) I admit investment growth will take a smaller part of GDP growth in the future, but not a far smaller part.

    China has still a big part of rural and other population without the necessary education and access to productive facilities. This implies that there are no labour market shortages yet: just get some more people from the rural areas!
    Northern Italy (and also Germany) applied this principle during the strong growth phases from the 1950s till the 1970s.

    Via the Cobb-Douglas production function, you see that capital is used more efficiently when applied to these still less employed human resources. I do not agree with your statement that investment is centrally planned and will fall rapidly. China is a capitalist country and – despite high borrowing rates influenced by the central monetary planners – smaller entrepreneurs still see possibilities and obtain credit even outside of the banking system.

    The higher utilisation of the (formerly) rural population leads to the typical Chinese investment-driven growth and rising productivity. I admit education and human capital will become more important now for China, while previously the built-up of capital prevailed.

    http://snbchf.com/2014/08/net-national-savings-alternative-indicator-to-gdp/

    4) Higher wage increases and the ever appreciating yuan thanks to investment inflows leads to a slow closing of the PPP gap to the U.S. (Balassa-Samuelson effect).

    Despite that, China manages to keep inflation rates low ! This reflects the effectiveness of capital usage and the productivity gains.

    5) Still the Chinese government has started to make lives of foreign companies more difficult, e.g. Volkswagen. And this makes sense: Thanks to increased wealth, capital comes now out of China far more than previously. China will need to reduce dividends/interest payments to foreigners. It only needs technology and skills and applies this principle very astutely.

    6) The massive build-up of productive investments and infrastructure compared to the neglected infrastructure in the United States, will facilitate stronger Chinese productivity.

    7) The recent slowing in China, stems mostly from slow consumer spending the U.S., austerity in Europe and austerity in the “fragile five” due to currency devaluation and higher inflation.

    Finally your projection is a pure population growth analysis. But since the Chinese population is four times bigger than the US, finally total Chinese GDP – measured in US dollars – will be between two or four times bigger than the one of the U.S.

    P.S. Remember that US population rises far slower than previously with +0.7% per year, mostly thanks to immigration.
    Then we can start discussing if China will be able to attract immigrants after 2060 or 2070, once Chinese has replaced English as global lingua franca. Japanese was not able to do so and that’s where most Japanese issues stem from.

    Reply
  6. In the early C19th, the Qing Empire was probably about a third of the population of the planet and about a third of global GDP. China is almost certainly never going to be that “dominant” again.

    The US economy only overtook the Chinese economy in size around 1880. Yet China had such a disastrous C20th, that we are having this discussion at all is a remarkable change.

    Of course, some academic commentators are so “off the planet” that they can dismiss the post 1979 changes as “creating class power”. Remarkable obtuseness.
    http://lorenzo-thinkingoutaloud.blogspot.com.au/2014/08/ahistorical-pomposity-and-gnostic.html

    Reply
  7. Ole Smidth

     /  August 28, 2014

    Looking purely at demographics, the relationship between USA and China will go from 5 Chinese in working age for every American today, to 3 in 2050. How much will they produce? It depends a lot on the (disturbing) role of the state, and the level of corruption.

    Reply
  8. brendan

     /  August 28, 2014

    “The American demographic challenges are somewhat smaller than is the case for China and I find it rather likely that the US gradually will adjust immigration policies so meet these challenges (I certainly hope so…)”

    Sure, Iraqis all hate each other’s guts, but 3.58 kids per women, so Iraqi demographics are a-ok!

    Is sheer quantity the only relevant demographic dimension?

    Is there *ANY* evidence that the forecast change in the US ethnic mix can be ignored when doing long term GDP growth forecasts? Or do we just assume that the United States has some intrinsic per capita income growth rate- 3%- and so future GDP will grow in direct proportion to population growth, regardless of the source of population growth?

    Reply
  9. Sinchan

     /  September 1, 2014

    Long run growth forecasts are not worth the “paper” they are written on – why bother?

    Reply
  10. Since China’s population will continue to be at least twice that of the US, the hypothesis that the Chinese economy will not become as large as that of the US is equivalent — I think — to saying that the Chinese GNP/cap will never be larger than half of US GNP/cap. That seems implausible to me. So I don’t understand how one can expect China not to eventually have a larger GNP than the US — unless China splits.

    Reply
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