Recently, the World Bank issued a report indicating that China will become the largest economy in the world in 2014 based on the GDP measurement with purchasing power parity (PPP). As some economists have correctly pointed out, a better way of ranking economic size across countries is the market exchange rate, not PPP. Based on the market exchange rate, in 2013 the largest economy in the world was the U.S. with a GDP of $17 trillion, followed by China’s $9.1 trillion. Using this measurement, many banks and research institutions forecast that China’s economy will surpass the U.S.’s sometime either in this decade or in the next two. However, contrary to these forecasts, my prediction is that it will take China much longer to surpass the U.S., if it ever happens at all. Let me explain.
My forecast for China’s GDP potential growth rate trend is 5.5% over the next 10 years (2014 to 2024), 4% from 2025 to 2034, and 3% from 2035 forward. Meanwhile, my forecast for the U.S.’s GDP growth is 2.5% over the next few decades. By these rates, China will surpass the U.S. in 2068. My forecast for China’s GDP growth seems pessimistic considering its average annual 10% growth rate over the past 30 years. However, I think my forecast is actually an optimistic one. When we see a country with persistently high growth, it is difficult to accept that it will not continue into the future. Extrapolation is easier to make and to be believed. In fact, we heard the forecasts in the 1960s and 1970s that said that the Soviet Union would surpass the U.S., and in the 1980s that Japan would surpass the U.S. Yet it did not happen and will likely never happen. Today the story is the same, but the player is now China. In light of this, we need to consider that extrapolation without truly understanding the context is a dangerous forecast.
China’s spectacular economic growth in the 1980s, 1990s, and 2010s is an example of a “catch-up” story similar to that of postwar Japan, Taiwan, and South Korea. From communist destitution, China emerged with a combination of a market system, urbanization, industrialization, savings and investments in physical and human capital, and an eagerness to jump on the boat of international trade, to export its manufacturing products to advanced countries using its comparative advantage of labor, and to import the diffusion of technology and knowledge from advanced countries, mainly the U.S. Since the East Asian growth models are similar, the past slowing down of Japan’s economy followed by Taiwan’s and Korea’s mostly likely predicts China’s own slowing.
In fact, China’s exports engine has cooled down significantly since 2008 after several years of unsustainable trade surplus with the U.S. and Europe. China’s economic slowdown should have occurred after the global financial crisis. But China hit the gas on another growth engine—investing further. The relentless pursuit of high growth has resulted in an extremely imbalanced economic structure for China’s economy. Today China’s investment share of GDP is 45%, much higher than the world’s average of 20%, while China’s consumption share is only 38% of GDP, much lower than the world’s average of 65%. Investments in physical structure, equipment, housing, and public infrastructure are usually a good thing because they bolster productivity, income, and consumption in the long run. But when China invests too much and too quickly in the short run, investment returns diminish rapidly, or even turn negative. Again, it is unsustainable. Therefore, the mentality that high growth is always good is distorted and needs to be changed. Otherwise, a recession or financial crisis will occur and force China to change.
That is why I suggest a 5.5% GDP growth forecast for China over the next 10 years (in which consumption growth is 8.5% and investment growth is 3%). By following this path, China’s economy will be able to rebalance to a better structure: consumption share of GDP: 50% and investment share of GDP: 32% by 2024. Note that any target or forecast of GDP growth rate higher than 5.5% will go against the goal of restructuring China’s economy. Beyond 2024, China’s population growth will approach zero, or even be negative. The dependency ratio will rise, and the pace of urbanization will slow. That is why I suggest a 4% growth rate from 2025 to 2034 and 3% thereafter.
By all means, as an authoritarian regime, China can mostly set and achieve any goal by paying any cost. China did that in the Great Leap Forward by melting household pots into steel only to see economic and humane disasters afterwards. Now I hope the ambitious plans, such as building a high speed rail across the Bering Sea to Alaska or building the Sky City Tower—the world’s next tallest structure—in Changsha within one year, will be reconsidered and reexamined in a more sophisticated way. Throughout Chinese history, empires were often tempted to undertake grand projects, like the Great Wall in the Ch’in Dynasty or Zheng He’s ocean fleet in the Ming Dynasty. Without passing a social and economic cost-benefit analysis in the long run, these ostentatious but inefficient investments are always short-lived and make little contribution to civilization.
Because of its tremendous population, for centuries China’s economy was the largest in the world. In the late nineteenth century, it was surpassed by the US. Yet, if we consider a measurement for standard of living, i.e., GDP per capita, even since the seventeenth century China has been falling behind Western Europe and North America. Why? In their book “Why Nations Fail (2012),” Robison and Acemoglu suggest that human history tells us that those nations fail because their political and economic institutions are not inclusive enough to foster competition and innovation. Is China inclusive enough? In forecasting China’s (or any other countries’) future, I think this will be the most important factor.
Without a genuine and profound political reform, China is likely to slip into the middle-income trap, which has hampered many countries in Latin America for decades. To avoid this trap and to have sustainable and healthy economic growth, China should take a look at the Worldwide Governance Indicators (WGI) published by the World Bank. There is a high correlation between GDP per capita and WGI across countries. China’s scores are below the world’s median. If China can improve its scores by focusing on issues such as accountability and rule of law, I believe China will prosper more in the future than my current forecast suggests.
William Yu is an Economist with the UCLA Anderson Forecast at the UCLA Anderson School of Management.