IMF Forecast: Can China Really Overtake the U.S. Economy by 2016?

According to the International Monetary Fund (IMF) "World Economic Outlook," China's output will surpass that of the United States in 2016 - only five years from now.

But don't worry. The IMF calculation is based on "purchasing power parity" (PPP), which does not reflect real money. It relies on projecting China's stellar growth rates five years into the future. And it relies on Chinese official statistics, which are more than a little questionable.

(In fact, after the media storm that resulted, the IMF apparently even soft-pedaled its prediction that China would leapfrog the United States in just five years; in a subsequent interview, an IMF spokesman reportedly said that, by non-PPP measures, the U.S. economy "will still be 70% larger by 2016." A recent World Bank forecast concluded that China could overtake the United States by 2030.)

This prediction - and the attention it continues to draw - serves a useful purpose, particularly if it's given the scrutiny that it deserves.

For global investors with China-based holdings, it reminds us of that country's long-term potential - and the fact that such potential is always tempered by near-term risk. For the rest of us, it reminds us that China's ascendance is inevitable - in fact, is already happening - and will be with us for a long time, even if that Asian giant isn't immediately going to overwhelm the rest of the world.

And for our elected leaders in Washington, the IMF report - false alarm or not - should serve as a wakeup call to attack and address the many problems that threaten this country's global leadership.

IMF Report: A Closer Look

I had some problems with this prediction from the moment it hit the headlines.

Let's start with the IMF statistics themselves. They measure gross domestic product (GDP) on the basis of "purchasing power parity," rather than by market exchange rates.

That makes sense if you're comparing living standards: If you are talking about what the typical China consumer can buy, he or she is about one-sixth as well off as his or her American counterpart, not one-twentieth.

However, the use of the PPP measure makes much less sense when looking at international trade or political power. That's because individual purchasing power includes such items as haircuts, which are much cheaper in Beijing than in Boston (except, doubtless, at a couple of very overpriced salons in Shanghai or one of the other burgeoning financial centers) and cannot easily be traded internationally.

On the other hand, goods that are traded internationally are subject to global market forces and are generally about the same price everywhere they are sold. In fact, some of those goods may even be cheaper in the United States, since our distribution system is more efficient and our tariffs lower.

That's also true of large-scale armaments; you will be able to get the People's Liberation Army (PLA) squaddies to work for much less than their U.S. counterparts, but the cost of a fighter jet or a missile with certain capabilities is pretty much standard around the world.

So even if the IMF's 2016 forecast was an accurate one, there's no way that China would be able to project as much military power as the United States, or to distribute as much foreign aid and subsidies to client states.

For at least a decade beyond 2016 - and probably more - China will be a substantial No. 2 ... a market that can't be ignored ... but not No. 1.

The Travails of Timing

When you are estimating future growth rates, the farther out you go, the more inaccurate your predictions become: If you were to take China's current growth rate and project it forward 50 years into the future, the Asian giant would have absorbed the whole of world GDP and be starting work on Mars.

Even a five-year projection - such as the one the IMF put forth - does not allow for the possibility that China will experience an economic hiccup before that period ends. The recent news that China has just fired the head of its $270 billion high-speed rail network for embezzlement, and is now running the trains 30 miles per hour slower than before for safety reasons, indicates that - in a command economy like China's - much of the apparently soaring output may have been wasted.

My 1990 Economist diary claimed that the centrally planned East Germany was richer than the free-market Britain; as a native Brit who had recently visited East Germany, I can tell you that this wasn't the case - in fact, it wasn't even close.

Indeed, when the Berlin Wall came down, we saw the former Comecon (Council for Mutual Economic Assistance) economies lose as much as 60% of their GDP as factories closed because their output was uncompetitive in the free market. Similarly, up to half of China's GDP may be wasted: Think of all the empty offices and apartment blocks, developed by state-guaranteed companies, all of which are held as assets on the balance sheets of China's banking system.

Long-term, there's no question that China has great potential. At the same time, however, I think it very unlikely that China's economy will make it to 2016 without a major banking crisis, which will knock back its GDP for several years.

Long-Term Potential/Near-Term Peril?

The IMF numbers aren't the only ones that I feel are suspect - so, too, are many of China's growth statistics. GDP figures are announced immediately after the end of each quarter, which given China's size and diversity means they must reflect the wishes of the leadership more than any measurement of reality.

Sometimes, of course, the leadership may wish to record lower growth, to show that some monetary or fiscal tightening is working. But I'll bet that most of the time, the temptation is to "round up," as opposed to rounding down.

Far too many Western analysts and observers spend most of their time in the major urban centers, where growth has been fastest, and therefore aren't aware of, don't get to see, or even purposely ignore, stagnant areas or places where central planning has wasted billions. The prolonged rapture about the Chinese high-speed rail plan by a number of U.S. commentators is one good example of a case in which too many reporters took too many of China's claims at face value and failed to examine the challenges and problems that were hidden by the hype.

So my guess is that, even now, China's GDP and growth rates are not as impressive as reported.

The bottom line: China is big, getting bigger, and its growth can't be ignored - especially given its long-term investment potential. But there are near-term challenges, many of them substantial. If China does not have a major economic trauma, then indeed by 2030 or so it will be close to overtaking the United States. But we have a lot more than five years in which to make the necessary adjustments.

Our leaders should use this as a wakeup call.

Actions to Take: An old adage tells us to hope for the best, but prepare for the worst. That's sometimes easier said than done. So-called "inverse funds" are one way to hedge against feared bad news, or even to "short" markets that an investor believes are due for a tumble.

In China's case, however, the "short" fund - the ProShares UltraShort FTSE/Xinhua 25 Fund (NYSE: FXP) - has far too great a "tracking error" to be worth buying - it managed to halve in value in 2007-08, when the Chinese market also halved, thus completely failing to achieve its objective.

Instead, it's worth thinking about what the United States must do in order to meet the economic challenge that China poses, and to look at Latin American countries whose prosperity must be made more assured. You might therefore look at the two countries - Mexico and Colombia - that would benefit from increased U.S. economic involvement with neighbors. One great way to play this: The iShares MSCI Mexico Investable Index Fund (NYSE: EWW).

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