Thursday, April 26, 2012

How Big, How Rich and How Developed? The State of Play in the World Economy

How we measure economies matters. To get a clearer picture of the world economy we need to look not only at size, but wealth, development and distribution. But even when measuring the size and wealth of economies, the method of measurement we choose will have a big impact on the outcome. On some measures the Chinese economy is due to overtake the US economy before the end of the decade, while on others it will take much longer. Looking at other measures it is clear that while China might be approaching the US in size, it still has a long way to go to match it in terms of per capita GDP and overall development.

Every 6 months, the IMF releases statistics for all the countries that make up the world economy. These statistics provide an opportunity to compare countries at a number of levels, in a way that provides some indication of past performance, current predicaments and future possibilities.

There are two ways to measure the size of economies. Firstly, we can convert the value of a country's gross domestic product (GDP) into US dollars and compare it to the GDP of other countries whose currencies have been converted into US Dollars also.

The advantage of this method is that it provides a neat comparison of a particular country with any other country at any particular time. Its shortcoming, however, is that it varies with the US dollar (USD) exchange rate with particular countries and doesn’t accurately reflect the cost of things within them. If a currency appreciates or depreciates (or equivalently) the USD depreciates or appreciates, the size of the economy will change.

If, for example, the renminbi was revalued (or appreciates) against the USD this would immediately increase the measured size of the Chinese economy in USD terms.

This shortcoming does not make USD-based measures completely spurious because in this example a higher valued renminbi would enable Chinese people and companies to buy more goods and services on the international market for a given amount of renminbi. It would also increase the purchasing power of the renminbi in terms of foreign investment. US companies, for example, would become relatively cheaper for Chinese investors.

When exchange rates do vary considerably over time, such as the dollar–yen exchange rate after the 1970s, this method may cause distorted measures of size. This is also relevant for the Australian economy. For example, compare the difference in 'size' of the Australian economy when measured at the time the Australian dollar was worth around 50 US cents in the early 2000s and when measured in more recent years when it has been mostly above parity. Although for measuring purposes the exchange rate is averaged over a period, exchange rate variation still poses significant problems.

Such discrepancies have led to the increased use of an alternative method of measuring the size of economies based on the concept of purchasing power parity (PPP). Statisticians measure purchasing power within individual economies and then make comparisons on that basis. PPP measures GDP adjusted to reflect different costs of living and production within different economies. As most travellers know, goods and services and production costs are considerably lower in some countries than they are in others.

We all know that the Australian dollar goes further in some countries and buys less in others. You can live, for example, much more cheaply on Australian dollars in Indonesia than you can in Sweden. A popular representation of PPP values is the Economist magazine’s tongue-in-cheek Big Mac Index, which compares the price of Big Macs around the world. A Big Mac in Sweden will cost you a lot more than a Big Mac in Indonesia or even the United States itself on US dollar adjusted terms in relation to a country's exchange rate.

According to PPP theory, the cost of Big Macs should be the same across countries once local currencies are converted to US dollars. Big Macs, however, are not really a good marker of PPP because they are generally considerably more expensive than local-food items in developing countries. This is why the World Bank constructs data using Geary-Khamis dollars, commonly referred to as international dollars as a basis for comparison.

If we compare what a given amount of dollars will buy in the Chinese economy and compare it to what a given amount of dollars buys in the US economy we can, according to advocates of this approach, get a better idea of the true size of the Chinese economy.

The problem with this method is calculating the different costs of production and living on an ongoing basis. To do a proper analysis of PPP, the World Bank compares a large range of goods and services. It is, however, very difficult to get a comparable basket of goods and services for diverse countries with diverse cultures and consumption habits.
The International Comparison Program (ICP) is a worldwide statistical partnership to collect comparative price data and compile detailed expenditure values of countries’ gross domestic products (GDP), and to estimate purchasing power parities (PPPs) of the world’s economies. Using PPPs instead of market exchange rates to convert currencies makes it possible to compare the output of economies and the welfare of their inhabitants in real terms (that is, controlling for differences in price levels).
We begin by considering the share of global GDP for the major economies on a PPP basis.

Share of World GDP on a Purchasing Power Parity Basis
Source: IMF (2012) World Economic Outlook Database, April

The data are ranked according to the estimates for 2011. The IMF lists, the latest year for which data is actual rather than an estimate, which is 2010 for most countries (2009 for the US). What this shows is a trend decline for the United States, Japan and Germany, and a trend rise in share for China and India. 

Top 5 Countries Share of Global GDP, PPP, 1980-2011

Remember that these are relative shares, so that the US economy has not actually gotten smaller over this period. Instead the faster growth of China and India and the recent recession and slow recovery of the United States and Europe has helped them to increase their shares.

On a PPP basis, Australia's share of global GDP has remained remarkably static declining from 1.3% of the world economy in 1980 to 1.2% in 2011. The Indonesian economy is now the 15th largest economy, passing Australia in size in the late 2000s.

The USD based measurements give a remarkably different picture, the most striking of which is the fact that China is less than half the size of the US economy on USD terms, while it is three-quarters of the US economy under PPP calculations. While China became bigger than Japan in the early 2000s on a PPP basis, it only surpassed Japan on a USD basis in the late 2000s.

On a USD basis, the Australian economy accounts for a much higher share at 2.1% of the total, compared to 1.2% on a PPP basis. Once again this has much to do with the fact that the Australian dollar is now worth considerably more than it was in 2000!

Share of World GDP on a US Dollar Exchange Basis, Current Prices

In 1985, due to the high value of the USD in comparison with other major currencies, the US reached 35% of world GDP, falling to 29.4% in 1987, by which time the USD had substantially declined in value against other major currencies. The same thing happened in the early 2000s as capital flowed into the United States and the exchnage rate rose. Recent years have seen a significant depreciation of the USD, which has enhanced the fall in the US share of the world economy on a USD basis.

While India is the world's third largest economy on a PPP basis, it is only the world's eleventh largest economy on a USD basis. Australia is also considerably larger than the Indonesian economy on a USD basis (2.1% compared to 1.2%). On a USD exchange basis, the Australian economy is nearly the same size as India's economy.

Share of World GDP on USD Exchange Basis Selected Countries 1980-2011 

When we compare the United States, Japan, China and India on a PPP versus USD basis, we can see how significant the method of measurement becomes. Simply, the USD exchange method favours the richer countries and PPP favours the developing countries.

USD v PPP Share of Global GDP, Selected Countries

Predictions about a continuing Chinese ascendancy rely on a faith in its continuing and uninterrupted growth. Given China’s internal difficulties, this remains a precarious assumption. It also faces the possibility of a worsening environment that could lead to slower growth.

China remains a poor country as the figures for GDP per capita on a PPP and USD basis show. China is estimated to rank 93rd on a PPP basis in 2011, while India is due to rank 128th. Note how many of the European countries have gone backwards in recent years with Iceland and Ireland suffering significant declines. (The ranking is via the figures for 2011, which are estimates.)

GDP Per Capita PPP, Selected Years, Current International Dollar 

GDP Per Capita USD, Selected Years

Another pertinent measure that helps us to gauge aggregate development rather than simply aggregate economic growth is the United Nations Development Program’s Human Development Index (HDI). The HDI attempts to provide a broader measure of progress than GDP by including life expectancy, literacy, education and GDP per capita.
Norway has topped the rankings in recent years, while Australia comes in at number two. With the massive impact of the financial crisis on Iceland, its ranking fell from 3rd to 14th in 2011.  The United Kingdom comes in at 28th and Luxembourg despite topping the GDP per capita on a USD basis comes in at 25th. Qatar, which tops the GDP per capita rankings on a PPP basis comes in at 37th.

Human Development Index (HDI) 2011 Rankings

The next table shows three of the components of the HDI - life expectancy at birth, mean and expected years of schooling. The HDI also includes GDP per capita, which we have shown above.

When adjusted for inequality, the United States drops 15.3% and 19 places. Korea drops 17 places. Iceland, however, improves 5 places, while Norway and Australia stay where they are.

The next table shows changes in the HDI over time. The big mover over recent years has been Hong Kong, which improved 14 places between 2006 and 2011.

HDI Trend 1980 to 2011

There are many other things we need to consider to get a full picture of the world economy and the various economies that make it whole, but the above analysis shows that our perception of size and performance often depend on our methods of measurement.
What the data shows is that despite the crisis, US economic dominance continues, but it also shows just how remarkable China's rise has been. On current trends, the Chinese economy will soon be bigger than the US economy on a PPP basis, but it will take quite some time to match it on USD terms. Unless, of course, the RMB appreciates significantly against the USD. Even currents trend do continue, China still has some way to go to challenge the US economy on a wider terrain than just size. 
Whatever happens over coming years, we should not mistake the relative economic decline of the United States for a decline in impact. The United States remains the indispensable political economy. While the Asian challenge to Western dominance will be the issue of the twenty-first century, we should be wary of substituting a possible future for present circumstances. Asia still has a long way to go along the developmental path and many hurdles to negotiate before its overall economic strength matches that of the West.

Tuesday, April 3, 2012

Europe, China, the United States: What Balance and Whose Payments?

It might be a little bit dorky, but one of my favourite times of the month is the arrival of Michael Pettis's newsletter China Financial Markets. This rather blandly titled missive always provides rational, well argued and interesting comment on the Chinese economy.

Pettis constantly rails against those who don't understand the basic accounting concepts of the balance of payments.

In October last year in relation to the possibility that China could help with Europe's debt problems, he argued that:
Europe does not need capital from foreigners. It is capital rich. In fact it is even a net exporter of capital. The reason certain European governments cannot borrow is not because Europe is capital poor. It is because these countries are perceived to be insolvent, and in altogether too many cases they almost certainly are. 
Bailing out an insolvent government cannot help it. It will give it time to work out its problems, many argue, but the historical precedents suggest that the quicker an insolvent country acknowledges its insolvency and demands debt forgiveness, the better off it is in the longer term. 
... an increase in foreign money inflows actually will make Europe’s problems worse. Europe needs more demand, not more foreign money. More foreign demand is the opposite of more foreign money.
Remember that a net increase in foreign capital means that foreigners are importing demand from Europe. But Europe needs them to export demand to Europe. More foreign capital inflows is exactly the wrong thing – and in fact what Europe really needs is to increase its exports of capital. Paul Krugman, by the way, makes almost exactly the same point when he says: “It is very difficult in real time to convince people that capital inflows pose a threat, no matter how obvious the numbers seem." 
But difficult or not, it is important that policymakers grasp this point and it is important that investors understand the consequence when policymakers fail to grasp it. The trade and currency wars that we are experiencing are nothing more than wars about exporting capital. Exporting capital is exactly the same as importing demand. Every country that wants to run a trade surplus is also by definition a country that wants to export capital. 
And of course every country that accepts net foreign capital inflows must also accept a trade deficit (or, more correctly, a current account deficit). This isn’t a theory. It is an accounting identity.
This sort of reasoning is counter-intuitive to many people. Some of my more knowledgeable students look incredulously when I argue that the United States would actually benefit from a decline in Chinese purchases of US Treasury securities because it is popular wisdom that China holds all the power now that the US is so indebted to Chinese borrowers.

For what its worth, I've always thought that the fact that China lends to the United States at low rates of interest (i.e. bonds) and then uses some of that money to invest to earn higher rates of interest in China was a good deal for the United States and an indicator of Chinese weakness rather than strength. The only problem with this view is that the increased liquidity created by Chinese purchases of US dollar assets was an important factor in the global and US financial crisis. But as Pettis makes clear, Chinese investment in the United States does provide an advantage for China in that it exports capital to and therefore imports demand from the United States. To be blunt, the balance of power in this situation is far from clear.

Pettis has repeatedly pointed out that many people fail to understand this balance of payments logic in regards to the US-China relationship.From his October 31st 2011 newsletter he writes:
Non-economists may think China, with its huge reserves and 9% GDP growth can weather a trade war more effectively than the US. For example in an otherwise interesting article in the South China Morning Post, Lanxin Xiang, a professor of international history and politics in Geneva, says the following:
China owns too many US government bonds and yet the central bankers have always discouraged the government from entertaining any thought of using them as diplomatic leverage in dealing with Washington. But throughout modern world history, using monetary instruments to achieve diplomatic aims is the norm rather than exception. One notable case was the Suez Canal crisis, when Washington threatened to stop market support for sterling to force the British withdrawal from the Anglo-French colonial expedition against Egypt's nationalist president Gamal Nasser. 
I believe Xiang has used the Suez Canal crisis argument before, and it is a very clumsy analogy. The UK desperately needed to import capital from the US in those days to support sterling, whereas today the US is eager to get China to stop exporting capital (there is, remember, no difference between intervening to weaken a currency and exporting capital, and Washington clearly wants China to reduce its intervention). It isn’t likely that a threat by the US to stop exporting capital in the former case is as credible as a threat by China to stop exporting capital in the latter case, but of course this is the kind of mistake that many who don’t understand central banking or the balance of payments mechanism make over and over again.
In fact most economists (economic historians and trade economists, anyway) know that trade wars usually switch demand from surplus countries to deficit countries. Instead of hurting the deficit countries, this actually causes faster growth in the latter, albeit at the expense of slower growth in the former. Trade and currency war, in other words, is bad for the world but not necessarily bad for the deficit countries.  
The thing to note here is that Chinese capital outflows involve the export of demand from the United States and therefore an increase in unemployment in the United States. An orderly fix of the global imbalances (see here for a 2010 discussion) will be required if the world is to avoid an eventual trade war. This means adjustments on both sides of the question, but if China continues to pursue an investment and export-led growth model its current account surpluses must be matched somewhere with current account deficits. The United States has been this major deficit country.

In Europe, Germany's surpluses have been matched by Spain's deficits. Australia also is a major deficit country, although our current account deficit has declined as domestic saving has increased and non-mining investment has moderated.

Pettis makes the point that China's lending to the United States is not a discretionary decision, instead it is a fundamental consequence of its growth model. From his January 8th 2012 newsletter he writes:
Chinese “lending” to the US government is not a discretionary decision that they can choose or not choose to do – it is the automatic consequence of a growth model that requires a trade surplus to absorb domestic overcapacity – the idea that the US government needs foreign funding is based on a very fundamental misunderstanding of the balance of payments.  The US government does not need foreign buyers for its bonds. On the contrary, it is in Washington’s best interest that foreign central banks sharply reduce their purchases of USG bonds.
He also highlights the need to make distinctions between 'deficits':
foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding. Capital account inflows must exactly match current account outflows. 
The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall. The difference between domestic US investment and domestic US savings, of course, is equal to the net amount of foreign savings imported into the US, and is also equal to the US current account deficit. In this case soaring US investment causes the US to have a current account deficit and leads foreigners to fund this excess investment.
This has some relevance to Australia because we have historically had an excess of investment over saving meaning that we generally run a current account deficit. This is not necessarily a bad thing if the investment is productive. That's a big 'if' and much of the foreign capital inflow into Australia involved household borrowing to buy (and, to a lesser extent, to build) houses, thus bidding up the prices of houses. This game has seemingly finished for the moment at least, partly because the household sector has such high levels of debt at around 150 per cent of disposable income (down from 160 per cent a few years ago).

Note that Pettis makes the point that the direction of causality between saving and investment and between capital exports and imports are not always clear cut. 
But the direction of causality can also run the opposite way. Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow.
There are several ways this can happen. One way is for the surge in foreign capital inflows to cause a sharp rise in what otherwise would have been unnecessary or unfunded investment – the real estate bubbles in Spain and the US might be obvious examples of this. Another way is for foreign savings to displace domestic savings, perhaps by funding a credit-fueled consumption boom.
But whether for good reasons or bad reasons there is no escaping the fact that net capital imports into the US, whether pulled by domestic needs or pushed by foreign needs, must be accompanied by a rising US current account deficit – this is just arithmetic. ...
Remember that saying that the US needs more foreigners to buy US government bonds in order to keep interest rates low is exactly the same as saying the US needs a bigger current account deficit in order to keep interest rates low. This cannot be true.
In a recent newsletter (20 March 2012) Pettis makes some astute observations about China and the way that many commentators assume that the Chinese leadership can fulfil their intentions. He argues that this is because they focus on intentions rather than constraints.
This failure to focus on constraints rather than intentions is why I think most analysts have gotten China wrong in the past five years. By misunderstanding how China’s growth model works, and how the functioning of the model forces certain kinds of behavior and prevents others, they have been much less skeptical about Beijing’s ability to execute its intentions than they should have been. I think we should be much less impressed by what the leaders say they will do, and much more concerned about how the constraints they face will limit what they actually can do.
This applies not just to China, but for any country and particularly Europe right now:
This is an issue not just for China, by the way, but for any country. For example, knowing the constraints imposed by the functioning of the balance of payments I am wholly unimpressed by what many senior German and European leaders say they expect to happen in Europe. The fact is that if we hope to see net repayments by peripheral Europe to Germany, we will also have to see a reversal in their respective current account positions, and so far this seems unlikely. Without the latter, however, the former is impossible, no matter how determined Madrid, Rome, Berlin and Paris might be to reduce debt in an orderly way.

So what are the economic options available to the Chinese leadership given both internal and external constraints?

Pettis argues that two initial assumptions are necessary.
The first is that the fundamental imbalance in China is the very low GDP share of consumption. This low GDP share of consumption, I have always argued, reflects a growth model that systematically forces up the savings rate largely by repressing consumption, which it does by effectively transferring wealth from the household sector (in the form, among others, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidize and generate rapid GDP growth.
The consequence of this is that investment levels must be kept very high. The question is how much investment can the Chinese government continue to make beyond the historically highest levels for any country ever!

According to Pettis this has "resulted in massive over investment and an unsustainable increase in debt. China cannot slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP."

Pettis's second assumption is that some sort of rebalancing in China is inevitable because its imbalances "cannot get much greater".
The first reason is the debt dynamics. Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a “lost decade” of very low growth.
At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP. How? When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but it will rebalance through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.
Pettis quickly points out that he is not suggesting a sudden China collapse, rather he is suggesting that re-balancing must occur eventually either in an orderly or disorderly fashion. It is debt that will eventually force China to re-balance.

Now it is at this point that some students ask me (the good ones I mean) why can't China use the huge amount of reserves it has to pay off its internal debts?

Once again the explanation requires some knowledge of the balance of payments and reserve banking - not every politics student's favourite topics! Instead of making an already complicated post even more complicated, I've provided an explanation here.

The real question about rebalancing is not that it will happen but when. Betting against China or assuming that its growth model is doomed once again reminds me of Keynes's reputed observation about the ability of markets to remain irrational for longer than individuals can remain solvent. Lots of scholars and investors have assumed and bet that China was destined to fail, but it ain't happened yet. Pettis canvasses the more positive arguments:
China bulls continue to argue that there isn’t yet a significant overinvestment problem in China, which implies that debt is not rising at an unsustainable pace, or if it is, that it can continue rising for many more years before the debt burden itself becomes unsustainable.
This also implies that the consumption imbalance is temporary and can resolve itself gradually and over time as the benefits of earlier investment begin to emerge and eventually overwhelm the total costs of those investments. Of course if this is true China does not need a surging current account surplus because if investment isn’t being wasted it can keep investment rising faster than savings for many more years. The current account surplus, remember, is just the excess of savings over investment. 
The key vulnerability of my argument, then, is whether or not you think investment in the aggregate is being misallocated in China and has been for many years. If you agree, then you must also agree that consumption must become a greater share of GDP over the next five to ten years. What’s more, you should also agree that the only way to increase the consumption share of GDP is to increase the household income (or wealth) share of GDP.
China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption. As I see it, the various ways in which this transfer can take place can all be accounted for by one or more of the five following options:
1.Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.
2.Beijing can quickly reverse the transfers in the same way. 
3.Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth. 
4.Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt. 
5.Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
Notice that all of these options effectively have China doing the same thing: In each case the state share of GDP is reduced and the household share is increased. There are however very big differences in how the changes are distributed among various parts of the household sector and the state sector. 
Different rebalancing scenarios have very different implications for growth and distribution. For Pettis, the real costs of rebalancing must fall on the state sector.
Remember that for the past twenty years, and especially in the past ten years, the state and business share of a rapidly growing economic pie was also growing, which meant extraordinary growth in the value of assets controlled by the state sector. The household share of the growing economic pie of course contracted, but the rapid growth in the pie ensured that households nonetheless saw their income grow quite rapidly even as their share of total income declined.
When we reverse this process, as we must if there is to be rebalancing, any slowdown in GDP growth will be minimally felt by the household sector (if the rebalancing is managed in an orderly way), but even a scenario of very high GDP growth must result in much slower growth in the value of state sector income and assets. Of course if GDP growth actually slows sharply, which I expect it will, the growth in the value of state sector assets will collapse and perhaps even turn negative. 
In my opinion this change in the growth rate of the state sector will be at the heart of the political economy choices, and difficulties, that Beijing will be forced to address in the nest few years. It is likely to be much easier to keep political leaders happy when the value of the state sector is growing comfortably in the double-digit range than it is when it is growing in low single digits, or even contracting.
The issue then, according to Minxin Pei, is whether the CCP will be 'happy' to let this happen. Pettis discusses economic constraints, whilst Pei talks about political constraints. Pettis goes through the positives and negatives of all the options outlined above:
As I see it these are ultimately the only options – or at least the major set of options – Beijing can choose to follow over the next few years if it wants to avoid a debt crisis. Of course Beijing doesn’t have to choose only one of the above options. What is more likely in fact is that policymakers end up choosing a combination. 
For example we can posit the following. Beijing can choose an intermediate path between the first and second options, and raise interest rates sharply over the next two or three years while also raising the value of the RMB by 10-15% in an overnight maxi-revaluation. 
In order to protect workers from the resulting surge in unemployment, Beijing can instruct state-owned companies and local governments temporarily to hire a huge number of workers for make-work programs (the fifth option) and initially pay for this by increasing borrowing (the fourth option). At the same time it can begin a massive program of privatization, which should include transferring ownership of land to peasants, and selling off assets and using the proceeds to shore up the social safety net and to pay down debt in the banking system. 
This would certainly work economically to rebalance China in a way that guarantees fairly high growth rates over the rest of the decade, but is it politically possible? Here I would defer to Minxin Pei, who might argue that the scale of privatization required is not possible politically. In that case China would end up being forced into rebalancing via the fourth option, with a long-term surge in government debt. 
And this is my point. If you believe my assumptions are correct, then you should agree that China has no choice but to follow one or more of these paths. If privatization is not an option, then a collapse in the economy caused by a rapid adjustment in interest rates and the currency (the second option) might be. If that is ruled out, then perhaps the outcome will be a surge in government debt (the fourth option again), and so on. 
This what I mean by the economic constraints that limit the choices Beijing can make. It doesn’t matter what anyone thinks or wants Beijing to do, if the plan violates the economic constraints, it cannot be done. To be really complete we should outline the political constraints, the environmental constraints, the demographic constraints, the external trade constraints, and so on, although of course this is way beyond my ability, but each of these exercises allows us to escape from the confusion of stated intentions and to focus on the possible.
Interesting times ahead.