Tuesday, November 20, 2007

How Rich is China?

A recent article in the Financial Times (thanks to Marginal Revolution for the pointer) suggests that some soon-to-be released numbers will show that living standards in China are 40% lower than had previously been believed.

Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).

But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.

But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.

One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.

How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.

And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.

I'll be following this story with interest....


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