China: The world’s largest economy?

China: The world’s largest economy?

China: The world’s largest economy?

Asia Pacific Economic Outlook, June 2014

The World Bank estimates that China’s GDP will overtake that of the United States this year. Yet the big question is whether China can sustain growth while reducing its dependence on credit expansion.


The Chinese economy grew 7.4 percent in the first quarter of 2014 versus a year earlier, and was up 1.4 percent from the previous quarter. This slower growth was a continuation of the slowdown that has afflicted China during the past year, although growth remained in a range that the government has targeted. The big question is whether China can simultaneously sustain growth while reducing its dependence on credit expansion.

What about the outlook for the coming months? One can partly infer the direction by looking at the purchasing managers’ indices (PMIs). Evidently, China’s manufacturing sector continues to decline, at least according to the latest PMI for manufacturing from Markit.1 The index moved from 48.0 in March to 48.1 in April. A reading below 50.0 means declining activity, so the index’s increase means that activity continued to decline, but at a slightly slower pace. This was the fourth consecutive month of decline. Separately, a Chinese government PMI for manufacturing indicates very modest manufacturing growth in April. The index was 50.4, up from 50.3 in March. The government index, separate from the better-known one issued by Markit, is heavily weighted toward state-owned companies. This report still suggests considerable weakness in the manufacturing sector. The subindex for export orders was especially weak at 49.1, indicating a decline in such orders. Some investors are hoping for more stimulatory measures by the Chinese central bank, such as a cut in the reserve ratio for banks. Yet boosting credit market activity is also risky because there may already be too much bad debt in the system and there is certainly excess capacity in industry. A more sustainable way to fix the economy would be to stimulate consumer spending rather than debt-fueled fixed asset investment.

It appears that, despite government efforts to the contrary, credit in the non-bank shadow banking system continues to rise rapidly. The government reports that, in the first quarter, trust company assets were up 8 percent from a year earlier. The country’s trust companies now have assets of 11.7 trillion Chinese yuan, or $1.9 trillion—a record high. The average return on trust assets has declined.

Recall that trust companies have been established to circumvent restrictions on formal banking. The trusts lend money to private enterprises (including property investors). They raise money by selling trust products to private investors, usually offering a return far higher than is available through formal banks. The trusts are often informally backed by banks. The problem is that trusts have loaned money for many projects that are not expected to generate positive returns. Increasingly, trusts could face trouble meeting their obligations and may require help from banks. Banks, in turn, could find themselves in trouble. Thus further growth of this shadow banking activity is worrisome. Although it contributes to economic growth in the short term, it creates more stress on the financial system in the longer run. It is thus not a sustainable model for future economic growth.

Is China No. 1?

For some time, we’ve known that China’s economy would eventually overtake that of the United States. Most estimates had pointed to the later years of this decade. Yet now the World Bank estimates that China’s GDP will overtake that of the United States this year.2 Two questions emerge: First, how is this determined? Second, does it even matter?

First, for the purposes of this exercise, the World Bank does not measure the size of China’s GDP at current exchange rates. If this were to be done, the US economy would still be far larger than that of China. Rather, the World Bank uses a “purchasing power parity” (PPP) exchange rate. That is, it converts China’s local-currency GDP to US dollars using an exchange rate that reflects the true purchasing power of the currency. How is this done? The World Bank takes a large basket of goods and services for the United States and determines the dollar price of this basket. Then it takes a similar basket in China and determines its renminbi price. The ratio of the renminbi price to the dollar price of this basket determines the PPP exchange rate. For example, if the US basket costs $100 and the Chinese basket costs 350 yuan, then the exchange rate is 350/100, or 3.5 yuan to the dollar—which is, in fact, roughly the World Bank’s estimate of the PPP exchange rate. Keep in mind that the current market exchange rate is roughly 6.2 yuan per dollar. The World Bank’s new figures on GDP are based on new estimates of the composition and price of that basket.

Second, does this matter? Not really. Clearly China has many residents, and its economy has grown very rapidly in recent years. The fact that it is now the world’s largest economy simply means that it generates enough goods and services to match the purchasing power of the United States. Yet China has four times as many people as the United States, so its per capita output is thus one-quarter that of the United States. In other words, it has a long way to go to match the living standards of affluent countries. Moreover, for a variety of reasons, China’s growth is likely to slow down in the future. Also, keep in mind that, at current exchange rates, the US economy is still far larger than that of China. In terms of China’s participation in the global economy, such as purchasing commodities and high-technology equipment from other countries, China’s purchasing power still lags considerably. The measure of GDP using a PPP exchange rate largely reflects the low prices of domestic services in China. For example, the prices of haircuts, restaurant meals, and health services are very low in China, thus effectively increasing the true purchasing power of a Chinese wage. This is one of the principal reasons for China being the “world’s largest” economy. From that perspective, the label is not very meaningful.

How bad is China’s income disparity?

In China the unequal distribution of income now exceeds that of the United States. This is according to a new study conducted by the University of Michigan in conjunction with several Chinese universities.3 In addition, income inequality ranked No. 1 among problems cited in a survey of Chinese consumers, ahead of corruption and unemployment.4 Thus it is no surprise that the government is keen to address this issue that threatens social stability. Indeed the government’s recent crackdown on corruption is part of a larger effort to address income inequality. Recent protests and strikes are a manifestation of the resentment that is brewing in China. The most common measure of income inequality used by economists is known as the Gini Coefficient. This measure is 0 when income is evenly distributed and 1.0 when it is completely concentrated in one person. In 1980 China’s Gini Coefficient was 0.30; by 2000 it was 0.41; today it is 0.55. In the United States, by comparison, it is 0.45. The rise in China’s Gini Coefficient was unusually rapid in the past decade.


View all endnotes
  1. Markit, HSBC China Manufacturing PMI, May 5, 2014,
  2. Chris Giles, “China poised to pass US as world’s leading economic power this year,” Financial Times, April 30, 2014,
  3. Lorraine Woellert and Sharon Chen, “China’s income inequality surpasses U.S., posing risk for Xi,” Bloomberg, April 29, 2014,
  4. Ibid.


Dr. Ira Kalish

Dr. Ira Kalish is chief global economist of Deloitte Touche Tohmatsu Limited.

Asia Pacific Economic Outlook, June 2014: China
Cover Image by Jessica McCourt (Cover), Stephanie Dalton Cowan (China)