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Foreign Policy

Under-estimating China

May 04 , 2011

The United States and China–the world’s two economic superpowers– met last week for the third installment of their Strategic and Economic Dialogue. There was plenty to talk about on the foreign policy side–the Middle East, terrorism, North Korea—and also on economic issues–currency, government procurement, and the Doha Round to name a few.

Beyond the specifics, the real issue for the United States and the world is really about China’s looming economic dominance. The president’s State of the Union address, after President Hu Jintao’s visit in January, showed the level of anxiety that policymakers feel about China as a potential rival and perhaps a threat, with growing economic, military and political power, including its bankrolling of American debt.

But judging from the reaction to the president’s speech, that threat is not viewed as imminent. The same was said, some pointed out, of the rise of Russia and Japan, 20 and 40 years ago, respectively, and those threats turned out to be false alarms.

But what if the threat is actually greater than policymakers suppose?

According to the International Monetary Fund, for example, total U.S. gross domestic product in 2010 was $14.7 trillion, compared with China’s $5.8 trillion, making the average American about 11 times as affluent as the average Chinese. Goldman Sachs does not forecast the Chinese economy overtaking that of the United States until 2025 at the earliest. Americans also draw satisfaction from their unmatched strengths of an open society, an entrepreneurial culture, and world-class universities and research institutions.

But these beliefs may be overly sanguine. The underlying numbers that contribute to them are a little misleading because they are based on converting the value of goods and services around the world into dollars at market exchange rates.

It has long been recognized that using the market exchange rate to value goods and services is misleading about the real costs of living in different countries. Several goods and services that are not traded across borders (medical care, retail services, construction, etc.) are cheaper in poorer countries because labor is abundant. Using the market exchange rate to compare living standards across countries understates the benefits that citizens in poor countries enjoy from having access to these goods and services. Estimates of purchasing power parity take account of these differing costs and are an alternative, and for some purposes a better, way of computing and comparing standards of living and economic output across countries.

My calculations (explained in greater detail on the Peterson  Institute web-site) show that the Chinese economy in 2010, adjusted for purchasing power, was worth about $14.8 trillion, surpassing that of the United States. And, on this basis, the average American is “only” four times as wealthy as the average Chinese, not 11 times as rich, as the conventional numbers suggest.

The different approaches to valuing economic output and resources are not just of theoretical interest. They have real-world significance, especially in the balance of power and economic dominance.

The conventional numbers would suggest that the United States has three times the capability of China to mobilize real military resources in the event of a conflict. The numbers based on purchasing-power parity suggest that conventional estimates considerably exaggerate U.S. capability. To the extent that the service of soldiers and other domestically produced goods and services constitute real military resources, the purchasing-power parity numbers must also be taken into account. The economic advantage China is gaining will only widen in the future because China’s GDP growth rate will be substantially greater than that of the United States for the near future. China can be expected to grow at about 6.5-7 percent over the medium term compared to about 2.5 percent for the US.

By 2030, I expect the Chinese economy to be twice as large as that of the United States (in purchasing power parity dollars). Moreover, China’s lead will not be confined to GDP. China is already the world’s largest exporter of goods. By 2030, China’s trade volume will be twice that of the United States. And, of course, China is also a net creditor to the United States.

The combination of economic size, trade and creditor status will confer on China a kind of economic dominance that the United States enjoyed for about five to six decades after World War II and that Britain enjoyed at the peak of empire in the late 19th century.

This will matter in two important ways. America’s ability to influence China will be seriously diminished, which is already evident in China’s unwillingness to change its exchange rate policy despite U.S. urging. And the open trading and financial system that the United States fashioned after World War II will be increasingly China’s to sustain or undermine.

How the United States and the world should deal with a rising, perhaps already risen, China is arguably the greatest issue for the international system today.

Arvind Subramanian is a Senior Fellow at the Peterson Institute for international Economics and Center for Global Development, and the author of a forthcoming book on China’s economic dominance.

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