Saturday, September 24, 2005

Quick and dirty conversion doesn't cut it for China

By Ross Gittins

John Howard committed an embarrassing blooper in a speech he gave in New York last week. But not to worry - Peter Costello fixed it up in his own speech this week.

Mr Howard predicted that "in the next decade, China will likely [sic] surpass Germany to become the third-largest economy after the United States and Japan".

Oh dear. Did our Prime Minister say that? And to think he said it to the Asia Society, while assuring the rivalrous Americans and fearful Europeans that "China's progress is good for China and good for the world".

The trouble is, he was using a terribly outdated and unscientific way of comparing the size of economies. In the process he greatly understated the extent of China's progress.

The quick and dirty way is simply to convert each economy's gross domestic product into a common currency - invariably, US dollars - at the prevailing market exchange rates.

But that's quite inaccurate and, these days, no self-respecting economist uses that method. It has two big problems.

First, in an era of floating exchange rates, a country's exchange rate with the US dollar bounces around from year to year in ways that say nothing about the relative rate of growth in each country's production of goods and services.

Second, and more significantly, the purchasing power of a US dollar varies greatly from country to country. It buys less in some European countries than it does inside America, for instance, but buys a lot more in developing countries than it does in the US.

The Organisation for Economic Co-operation and Development and others have gone to enormous trouble to determine the differing prices of many goods and services in many countries and so work out a special set of exchange rates that would cause the US dollar to have equal purchasing power in every country.

And note that, according to economic theory, these "purchasing power parity" exchange rates are the ones that should prevail in foreign exchange markets and eventually will. That is, over the longer term, market exchange rates will conform to PPP.

It turns out that, when you work it out properly, China goes from being the seventh largest economy to the second, overtaking Italy, France, Britain, Germany and Japan.

As Mr Costello remarked in a speech to the Lowy Institute for International Policy this week, China's economy is already nearly twice the size of Japan's economy and three times the size of Germany's.

When you work it out properly, America's $US11,600 billion-a-year economy goes from being 29 per cent of the world economy to 21 per cent. Japan goes from 12 per cent to 7 per cent.

But China goes from 4 per cent to 13 per cent. And India goes from less than 2 per cent to almost 6 per cent, lifting it to fourth position overall.

How can China and India have such huge GDPs? Well, not because they're rich, but because they're so big. China is the most populous country with 1.3 billion people and India is next with 1.1 billion.

This gives them 20 per cent and 17 per cent of the world's population respectively.

At present, America's corrected GDP is 60 per cent bigger than China's. That's because it has the third-biggest population in the world - almost 300 million - and is by far the richest country on a per-person basis.

Where does Australia stand in all this? Our 20 million make us the 53rd biggest country by population and give us a share of the world population of less than a third of 1 per cent.

But we have the 16th largest economy in the world with a 1.1 per cent share of global GDP that's four or five times larger than our share of population.

Why are we rich even though we're not big? Because we have a high level of productivity. That is, we're able to produce a lot of goods and services per person.

Why are we so productive? Because we have a relatively highly educated workforce (human capital), because our workers have a lot of machines to work with (physical capital) and because we have up-to-date machines and know how to work them (advanced technology). We also own a lot of valuable natural resources.

But, having explained all this, Mr Costello went on to sketch out how the world may look in 2050 if present trends continue (which, of course, they may not).

If the global population in 2005 is represented by 100 people, then five are in the US, 11 in Europe, 20 in China, 17 in India and 14 in Africa. If we project forward to 2050, the global population would have risen by 40 per cent.

But if we standardise back to 100 again we'd see the US proportion of global population has hardly changed. Same for India. Europe's proportion would have fallen to seven.

This may surprise you: China's share would fall to 15. Why? Because its One Child policy gives it a fertility rate about as low as ours. And here's another surprise: Africa's share of the 100 would rise from 14 to 21. "The big population shift in the next half century will be to Africa," Mr Costello said.

Turning from population to economic growth, it's well known that China's GDP

has been growing at the annual rate of about 9 per cent for the best part of 25 years. So much so that China now provides the single greatest source of world economic growth.

"As India continues its decade-long emergence from the dead hand of socialism and further opens itself to international markets, much the same has started to occur, although it is not as advanced yet as China," Mr Costello said.

If we project current trends forward to 2050, we find that China's share of global GDP would rise from 13 per cent to 20 per cent, with India's going from 6 per cent to 12 per cent.

America's 21 per cent would fall to 14 per cent, while Europe's fell from 21 per cent (note that, at present, the European Union's economy is about as big as America's) to 10 per cent.

This suggests that China and India are likely to be completing their re-emergence as major powers. Why "re-emergence"? Because, until about 1700, China and India were nearly as rich as Europe in per-person terms. In 1700 they accounted for half of global economic activity.

The industrial revolution began in Europe and spread to America, but now is reaching Asia.

Ross Gittins is the Herald's Economics Editor.

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