In memory of Dr. Andreas Höfert

On China’s size

| Tags: Andreas Höfert

One hundred and forty-two years: this is how long the US was the world's the largest economy. In 2014, according to the International Monetary Fund, it had to pass the baton back to China. This New Year’s Eve China will represent 16.5% of the world’s purchasing-power-adjusted GDP (USD 17.6trn), with the US at 16.3% (USD 17.4trn).

China is in fact taking back the top spot. According to studies by the late Angus Maddison, the leading expert in historical GDP estimation, it was No. 1 between the sixteenth and early nineteenth century. And barring catastrophes, it is likely to hold onto its top ranking for the next several decades. It may be challenged at the end of this century by India, though this extrapolation is very far in the future and highly uncertain.

While this news of China becoming the world's largest economy has been widely commented on, it comes as no surprise. For the last 10-15 years, many economists who look at longer-term trends have forecast its ascendance. In 2006, we at UBS wrote several articles on the shape of the world to come, pointing to the relative economic decline of the developed (or Western) world and the relative rise of the emerging markets. Despite recent setbacks in many of those countries due to the surge of the dollar, geopolitical tensions and the fall in commodity prices, the underlying trend of emerging markets gaining more weight in the world economy remains intact.

It is easy to make this call. China’s population is over four times larger than the US's. And China is currently converging, which means that its GDP per capita is catching up with the US's. The convergence phenomenon, i.e. that poorer countries in GDP-per-capita terms tend to draw closer to richer countries, is well documented. In the 1950s and 1960s, Germany and Italy illustrated this phenomenon; in the 1960s and 1970s it was Japan. In the 1980s the famous Asian tigers (South Korea, Taiwan, Hong Kong and Singapore), as well as Spain and Ireland in Europe, converged.

Today, it is the turn of other emerging markets. GDP per capita in China is less than one-quarter of the US's today and compares with Jordan's or the Seychelles'. So there is still more room for it to converge. While the phenomenon of convergence is well documented, however, economists still have difficulties explaining it. Why do some emerging markets converge while others don’t? And why do some suddenly stop converging, becoming stuck in what economists call “the middle income trap,” as Brazil and South Africa have?
One answer might be the strength of institutions, especially with regard to proprietary rights and the rule of law. The more solid such institutions as courts and government agencies are, the more likely a country is to converge. China seems well aware of this, if one recalls its reform plan presented last year at the Third Plenum of the Chinese Communist Party’s 18th Congress.

That said, does the economic size of a country really matter? It depends on what the specific country wants to achieve. The US remains the world’s leading military power and spends roughly 4% of its GDP on defense. According to the Stockholm International Peace Research Institute, US defense spending exceeds that of the next eight largest countries combined; it is roughly 3.4 times larger than that of China (the second-largest country in terms of defense budget). If China spent the same proportion of its GDP as Russia (No. 3 in terms of defense budget) does, it would nearly match US defense spending. However, China’s ambitions are likely broader than just becoming a military rival to the US. In the long run outgrowing instead of outgunning the US is, in my view, a better option not only for China but the rest of the world.