The Truth About China's Economy

Some say it could pass the U.S. by the end of the year. There might be an even bigger story behind the scenes.

The World Bank just put out a report suggesting that the Chinese economy would overtake that of the United States by next year to become the world’s biggest economy measured by its currency's purchasing power. “The estimate by the World Bank's International Comparison Program says that based on 2011 prices, the purchasing power of China's currency, the yuan, was much stronger than was reflected by exchange rates,” says USA Today.

The World Bank report caused quite a fuss in the media, but the methodology behind it is questionable. CNBC reported breathlessly that “China is set to overtake the U.S. as the world's number one economy, while India has jumped into third place ahead of Japan, according to a new study from the world's leading statistical agencies.” Other media outlets that ought to know better followed suit.

First and foremost, using purchasing power parity to make such a comparison confuses apples and oranges in an economic sense. “Living standards of the average Chinese citizen are still far lower than those in many developing countries, let alone in the West,” notes Jamil Anderlini, Beijing bureau chief of the Financial Times who has lived in the country for more than a decade. He continues:

“Today, inequality in this nominally socialist country is now much worse than the US, the epitome of a capitalist country. The level and availability of social services such as health, pensions and unemployment benefits are also much lower proportionally than in the US and even many other developing countries.”

Even the Chinese government itself expressed reservations about the methodology used by the World Bank. But the more fundamental issue for analysts should start with the nature of the Chinese political economy and the veracity of economic data in China. There is no separation between church and state in China. There is only the state.

The economic statistics issued by the Chinese government are designed to help maintain the control of the Chinese Communist Party in a political sense, not to better inform China’s people or foreign investors. The fact that the World Bank, foreign news agencies and investors are willing to take Chinese statistics at face value says more about the credulity of foreign audiences than it does about China’s authoritarian government.

Even if we decide to take Chinese economic statistics at face value, however, prudent analysts still need to ask some basic questions about the fundamental factors behind the claims of job growth and output. China's economy reportedly grew at an annual 7.4 percent in the first quarter of this year, slowing from a 7.7 percent increase in the final quarter of 2013, numbers that seem too good to be true—and they are.

Some of the better alternative sources on the Chinese economy, such as the U.S.-based China Beige Book, reports that “the economy slowed broadly this quarter and saw even starker deceleration on-year. Every sector except transportation slowed from last quarter, with revenue growth in manufacturing and services easing and that in retail, mining, agriculture, and especially real estate weakening more sharply.”

Part of the difficulty facing foreign analysts is that they tend to think of the Chinese economy in their own terms, comparing China to a Western-style market economy with functioning financial institutions and credit markets. Instead, the correct way to view China is closer to the old Soviet allocation model, where the state and the Communist Party make decisions to allocate resources to one sector or region, often based on political consideration rather than any clear economic logic. The fact that half of Chinese GDP is based upon state direct investment is a clear red flag.

James Rickards, author of the new book “The Death of Money” and a long-time China analyst who visits the country regularly, notes that the new, largely empty cities springing up around China are not so much a sign of economic growth as the desperate creation of work and infrastructure that consumes resources and produces no economic output.

Rickards believes that if you discount China’s economic statistics to reflect the cost of malinvestment, corruption and cronyism between members of the Communist Party and state-controlled banks and companies, the actual GDP growth rates are perhaps half the officially claimed rates. Moreover, this type of infrastructure spending is not only wasteful, but it is unsustainable. He notes:

“The threat from malinvestment in infrastructure, asset bubbles, overleverage, corruption and income inequality are routinely downplayed by Chinese authorities. These threats are viewed as growing pains in the birth of a new China as opposed to an existential crisis in the making. The larger issue for China’s leadership is the impossibility of rebalancing the economy from investment to consumption without a sharp decline in growth. This slowdown, in effect the feared hard landing, is an event for which neither the Communists nor the world at large are prepared.”