Will China excel US in 2016?

The publication of the latest World Economic Outlook (WEO) last month by the International Monetary Fund (IMF) has drawn much attention for an unexpected reason. According to the half-yearly WEO report, China's GDP is expected to surpass that of the United States by 2016. Less attention is paid, however, to the measure in which this comparison is made.

When comparing the value of different countries' output, each country's statistics in local currency must be converted into a common currency. However, the selection of a measure for the conversion depends on what one wants to compare.

Related readings:  China's GDP to triple by 2030: BCG  WB raises China 2011 GDP forecast  China's GDP to grow 9.6% in 2011: IMF  World Bank raises China 2011 GDP forecast

In the WEO, the IMF uses the purchasing power parity (PPP)-adjusted GDP. This is a yardstick that tries to measure the total volume of goods and services produced in one country with that of another. To do so, currencies are converted using the PPP exchange rate, which is a relative price that ensures the same purchasing power of broadly similar basket of goods and services across countries.

Why would the conversion based on the market exchange rate not ensure the same purchasing power? There are many possible reasons, including different levels of development, quality of products that are not fully reflected in prices, and household preferences. For example, the price of a traded good that can flow freely across borders such as a computer (after adjustments for transportation and taxes) should be broadly similar across countries. However, the price of a non-traded product such as a haircut or eating out could be different. Different preferences assign different relative values to products specific to each country.

Furthermore, during the development stage, productivity of the non-traded sector is usually lower than that of the traded sector. Since prices of the traded sector should be broadly similar between a developing and a developed economy, the average price of goods and services in developing countries is usually below that in developed economies.

How would a PPP-adjusted GDP differ from a market exchange rate-based GDP comparison across countries? We would expect to see countries with greater gap between prices of non-traded and traded products, and countries with larger non-traded sectors gain most in a PPP-based comparison. Moreover, since PPP is measuring the actual volume of goods and services provided, it is generally regarded as a better measure of social welfare.