BEIJING ― Last week, Chinese Premier Li Keqiang unveiled China’s 2017 economic target of 6.5 percent GDP growth at the annual meeting of the National People’s Congress in Beijing. This is the lowest target the government has set in over 20 years.
This announcement is an opportune moment to evaluate the great economic rivalry of our generation ― between the U.S. and China. For the past 19 years, up until 2016, China’s GDP at market exchange rates (also called dollar GDP) has grown faster than America’s. Dollar GDP growth rate is different from the real GDP growth rates, which are measured in local currencies, and are better for cross-country comparisons.
Last year, there was a reversal in the growth rate of dollar GDP, with the U.S. growing faster than China; China’s dollar GDP grew only 1.2 percent, compared to 3.5 percent in the U.S. This hasn’t happened since 1999, when China suffered a banking crisis. The 2016 reversal was driven by a precipitous 7 percent drop in the value of the yuan, which was caused, among other factors, by capital flight, a potential symptom of deep and significant problems in the country.
The 2016 reversal in dollar GDP growth rates raises three key questions: First, how does the 1.2 percent dollar GDP growth for China square up with the more widely reported 6.7 percent real GDP growth? Second, what have been the causes of the fall in the value of the yuan? And third, what are the implications of the reversal, and is it likely to continue?
What accounts for the different growth statistics?
Two factors account for the difference between the more widely reported statistics of real GDP growth and dollar GDP ― inflation and change in exchange rates. China showed a more robust GDP growth of 6.7 percent in 2016 compared to 1.6 percent in the U.S. Inflation, measured using a GDP deflator for both economies, was roughly similar, with China at 1.5 percent and the U.S. at 1.9 percent. The yuan vs. dollar exchange rate declined by nearly 7 percent through 2016 and was the key driver of the difference between the real GDP and the dollar GDP.
Why did the yuan fall?
There are two main reasons for the significant fall in the value of the yuan in 2016. The first and most important reason is capital flight. The second is a strengthening of the U.S. dollar more generally.
Capital flight is driven by a worrying perception of weakness in the Chinese economy, particularly in the banking sector, and an expectation that the economy will continue to slow. People want to allocate their capital to more productive ends or to diversify their exposure in case of a significant negative shock or financial crisis.
Capital flight is also caused, in part, by the anti-corruption drive led by President Xi Jinping. Some high-net-worth individuals, whose wealth is sometimes illegally obtained, are trying to take their money outside of China. Recognizing the negative impact of capital flight, the government intervened by tightening capital controls. Given that the outflow of the yuan has been severely restricted by the Chinese government, there is potential for further weakening if capital controls are relaxed over time.
The U.S. dollar has also strengthened against most major currencies, particularly since President Donald Trump’s election. This is driven by an expectation of faster increase in interest rates by the Federal Reserve, stronger fundamentals in the U.S. economy with rising wages and the expectation of a fiscal stimulus and significant tax cuts under the new administration. All of these factors attract capital back to the U.S. and result in an increase in value of the dollar.
What are the implications going forward?
Nevertheless, the prospects for China’s economic growth are brighter than America’s; over time, China is likely going to continue to rise relative to the U.S.
The key lesson from 2016 is that this trend is no longer going to be smooth and steady ― it might take longer than analysts currently expect. Going forward, there could be more years, similar to 2016, when America’s GDP grows faster than China’s. The 2016 reversal, along with potential for further weakness in the yuan, will push back estimates of when China’s dollar GDP will surpass America’s. It is likely to occur sometime between 2027 and 2033, not between 2018 and 2026, the prevailing forecast.
In other words, the U.S. will likely remain the largest economy in the world for at least the next 10 to 15 years.