China's rapid economic growth since 1979 has transformed it into a major economic power. Over the past few years, many analysts have contended that China could soon overtake the United States to become the world's largest economy, based on estimates of China's economy on a "purchasing power parity" (PPP) basis, which attempts to factor in price differences across countries when estimating the size of a foreign economy in U.S. dollars. However, in December 2007, the World Bank issued a study that lowered its previous 2005 PPP estimate of the size of China's economy by 40%. If these new estimates are accurate, it will likely be many years before China's economy reaches U.S. levels. The new PPP data could also have an impact on U.S. and international perceptions over other aspects of China's economy, including its living standards, poverty levels, and government expenditures, such as on the military. This report will not be updated.
Measuring the Size of China's Economy
Since embarking on a road of free market reforms nearly three decades ago, China has been one of the world's fastest growing economies. The actual size of China's economy has been a subject of extensive debate among economists. China reports that its 2005 gross domestic product (GDP) was 18.4 trillion yuan. (1) Using average annual nominal exchange rates (at 8.2 yuan per dollar) yields $2.2 trillion, equal to less than one-fifth the size of the U.S. economy. (2) China's per capita GDP (a common measurement of living standards) in nominal dollars was $1,761, or 4.2% of U.S. levels. These data would indicate that China's economy and living standards in 2005 were vastly below U.S. levels. However, economists contend that these figures are very misleading. First, nominal exchange rates only reflect the price of currencies in international markets, which can vary greatly over time. (3) Secondly, some exchange rate mechanisms, such as between the dollar and the Chinese yuan, may be significantly distorted by foreign government intervention. (4) Finally, nominal GDP data fail to reflect differences in prices that exist across nations. Surveys indicate that prices in developing countries (such as China) are generally much lower than they are in developed countries (such as the United States and Japan), especially for non-traded goods and services. Thus, a measurement of a developing country's GDP expressed in nominal U.S. dollars will likely understate (often significantly) the actual level of goods and services that GDP can buy domestically.
Purchasing Power Parity and GDP Size
Economists have attempted to factor in national price differentials by using a purchasing power parity (PPP) measurement, which converts foreign currencies into a common currency (usually the U.S. dollar) on the basis of the …