(Letter) How fast China can catch up the US in GDP? It may be faster than you think.
If we assume the relative paces of the underlining economic numbers remain the same, China will catch up the US in 2019. That’s scenario #1. The key underlining economic numbers are: nominal GDP growth and currency exchange rate.
Between 2002 and 2007, the compound annual nominal GDP growth of China was at 19.2% (in yuan term), and the compound annual nominal GDP growth of the US was at 5.79% in dollar term). The difference was much larger than the headline real GDP growth difference. The main reasons are:
#1 China’s GDP deflator is larger and likely overstated compared to the US’. For instance, the 2Q08 China GDP deflator was at implicit 10.6%; and the 2Q08 US GDP deflator was at supposed 1.1%. The difference is breathtakingly extraordinary if you consider CNY was quite a bit stronger than USD between 3Q07 and 2Q08.
#2 China had a one-time 16.8% upward GDP revision in 2005, mostly readjusted for its understated service economy. Was the revision a one-time event, or likely repeated down the road? In 2007, the service economy of China was 39% of the total economy. For instance, Egypt, which has a roughly 30% lower per capita GDP, has its service economy at 54% of the total economy. Is China’s service economy less developed than Egypt’s, or is it simply understated by the Chinese statisticians — that will require further upward revisions down the road? I tend to believe it’s the latter. For anyone who has traveled to Egypt, judged by the available restaurants, shopping malls, and the number of domestic leisure travelers, it’s very hard to fathom China’s service economy isn’t anything but far more developed that Egypt’s.
The other crucial factor is the exchange rate. on 12/31/02, CNY:USD was at 8.2788; and on 12/31/07, CNY:USD was at 7.3031. Very few dispute CNY is undervalued compared to USD, and the Chinese government has been for the large part in recent history, suppressing the advancement of CNY. As to the reasons, the best theory I have heard is that a large part of the Chinese are still farmers. If the value of CNY is to be too high, they can’t compete with the farmers of other countries, hence the Chinese government will have to suppress the value of CNY to appease this bulk of its constituency, at the expense of other Chinese consumers. The fact that CNY rises the fastest during the world food commodity price increase, and a rising CNY didn’t seem to hurt China’s manufacturing exports, adds credence to this theory. If we go by this theory, continuous urbanization and elevated world food price will take that pressure away, and China will eventually let CNY go. That may make some low-end exporters unhappy, but Chinese consumers should benefit.
How fast can CNY rise? You can easily imagine a black swan case that is similar to geological magnetic polar flip, i.e. USD becomes a discredited international currency and CNY is to replace it. But I will take that out of the equation, and compare to a recent milder version of appreciation: Brazil Real between 2003 and 2008. Still being a developing country, Brazil benefited from rising commodity prices and sounder monetary and fiscal policies, has seen its currency compared to USD per Big Mac Index rising from 48% undervalued, to 34% overvalued. The scenario #2, assumed CNY can rise to BRL’s valuation (per Big Mac Index), will put China’s GDP overtaking the US’ in 2013.
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