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Economy

It's a PPP world, but so what?

China will edge out the U.S. this year to become the world's biggest economy, then move quickly ahead in the years to come. Japan's 4.8% share of world output is barely more than half what we thought it was. It is significantly smaller than India's 6.4% and now trails that of the Commonwealth of Independent States, comprising Russia and other former Soviet republics. The combined share of the Group of Six countries -- the U.S., Japan, Germany, France, the U.K. and Italy -- is now smaller than the 35% of the BRIC economies (Brazil, Russia, India and China) plus Mexico and Indonesia. The tectonic plates of the global economy have shifted toward the emerging world further and faster than previously thought.

     That, at least, is the recently published finding of the World Bank's International Comparison Project, a global statistical partnership updated to 2014. We are duty-bound to ask whether these findings matter, and if so, how?

What is it all about?

The simple way to compare countries is to take their gross domestic product and convert the values to a common currency, normally the U.S. dollar, using market or constant exchange rates. Some statisticians don't think this is legitimate or accurate because of the large differences in costs and prices between richer and poorer countries. Instead, they use data on prices and expenditure values, and estimate the so-called purchasing power parities of economies, using PPP instead of exchange rates.

     Price discrepancies are ubiquitous in goods and -- notably -- services that are not traded across borders. Although tariffs, subsidies and trade costs lead to differences in prices of traded goods, nontraded goods and services vary much more, and are determined by local circumstances, especially by wages and salaries. Economists typically emphasize haircuts as an example of a service, which, strictly speaking, should cost the same in Tokyo, Beijing, New York or Buenos Aires. But market services and, for example, buildings, construction and government services, are hard to compare. Moreover, currency values are influenced by government policies, speculation, interest rates and capital flows. PPP exchange rates allow for the fact that poorer countries have lower costs, prices and exchange rates relative to richer countries. They also tend to correct themselves for such discrepancies, providing what statisticians claim is a better idea of relative size of spending and purchasing power. Hence the new picture of the global system.

     Assuming the statistics reported by 199 countries around the world are accurate, we can say that for most practical purposes, the new PPP version of the world economy makes no difference to anything whatsoever.

     No one has a PPP bank account. No transactions in world trade and investment are conducted at PPP exchange rates. No flows of money and capital occur at PPP values. The PPP exercise does, however, throw up at least four interesting issues.

     First, China's 1.3 billion people or India's 1.2 billion should be able to produce more GDP than America's 318 million or Japan's 127 million. The fact that this is happening is remarkable, but needs to be put in the context of explanations about why economic development happens and when it becomes constrained.

     Second, the new PPP estimates suggest that emerging countries are much closer to becoming middle-income countries than many economists thought. That is good news, but it also means they are much closer to the risk of getting stuck in a middle-income trap. Successful economic development gets harder and depends more on robust institutions, as opposed to graft, as income per head goes up.

     Third, adjustments to the size of GDP in China and other emerging markets don't alter reality: These countries are still relatively poor. If you look at income per head, the ICP's data show China in 2011 at $10,057, compared with a prior estimate of $5,456, and India at $4,735, compared with $1,533. These compare with over $49,000 for the U.S., and $34,000 for Japan. The prospect of even catching up with, let alone surpassing, developed economies remains distant and uncertain.

     Fourth, while statisticians might argue that a haircut should be valued more comparably between richer and poorer countries, this makes no allowance for quality. It is normal for quality differences to be large, reflecting discrepancies in productivity, the endowment of capital, tools and skills. Personal care services, for example, in Tokyo are likely worth more on average than they are in Mumbai or Shanghai, because they are better.

     In the end, size of GDP doesn't really matter because lasting success in countries such as China, especially as they become richer, depends on the complex task of building strong governance and robust institutions.

     But in a geopolitical sense, size does matter. Size and economic weight could embolden countries such as China in the conduct of international relations, in international institutions, in regional trade and financial arrangements. But we should be wary. It is reported that China was uncomfortable with the substance of the ICP report for fear of being expected to play a more responsible global role. A confident China wouldn't balk at that prospect. A China that lacks confidence might use its weight in less predictable ways.

George Magnus is a former chief economist at UBS and author of "Uprising: Will Emerging Markets Shape or Shake the World Economy?"

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