Chinese GDP is Overstated

July 7th, 2011
in Op Ed

China flag by Michael Pettis

Last week a friend sent me an interesting article that came out in one of the MIT magazines. According to MIT News:

A recent study released by the MIT Joint Program on the Science and Policy of Global Change quantifies the damage to the Chinese economy caused by a lack of air-quality control measures between 1975 and 2005. Not surprisingly, the MIT researchers found that air pollutants produced a substantial socio-economic cost to China over the past three decades.

Follow up:

…To observe how changes in pollutants, and their associated health impacts, have historically affected the Chinese economy, the MIT researchers modeled the number of cases of health incidences caused by air pollution — such as restricted-activity days, respiratory hospital admissions and asthma attacks, to name a few examples — given a pollution level and the number of people exposed. Then the model calculated the summed costs of these incidences — i.e., payments for health services and medicine, loss of labor and productivity from time off work, loss of leisure time needed for healing — to estimate the total change in available labor supply.

Similar studies conducted by the World Bank have found that air pollution in China caused damages equal to 4-5 percent of the Chinese GDP between 1995 and 2005. However, these estimates are based on static measurements that do not measure the cumulative, long-term impacts of health damages. The MIT study found a significantly higher level of damage, equaling 6-9 percent of the Chinese GDP. The dynamic, cumulative method used in the MIT study may be particularly applicable to developing countries that are experiencing rapid growth.

I mention this because I have often argued that Chinese GDP growth has been substantially overstated during much of the past thirty years. Part of the reason for the overstatement is that the future costs of environmental degradation should in principle be included as a deduction to current growth.

After all if environmental degradation reduces future economic output because of health problems, not to mention because destroying rivers, farm land, and so on is the economic equivalent of selling assets and calling the proceeds income, then the growth in economic value it generates today should be reduced by the destruction in economic value.

So what is China’s real GDP?

This is hard to do, of course, but it eventually gets accounted for in the form of lower growth in the future. If farmers produce less tomorrow because water is polluted, then future economic value added is lower. If workers spend additional money on health care tomorrow, this money is transferred from other, more productive spending.

This happens everywhere, of course, but I would argue that in many countries, where environmental degradation has been less and has occurred over a much longer period, it is already showing up in lower GDP growth today, so it probably results in a much lower overstatement of growth. In fact in rich countries where environmental degradation has slowed sharply, or even reversed, it may be causing GDP growth to be understated.

The other source of GDP overstatement in China is misallocated investment. One way of thinking about it is that if NPLs were correctly identified, the annual accumulation of the non-collectible portion of NPLs should be deducted from current GDP growth numbers to arrive at a more accurate estimate of GDP. After all growth “created” by wasting money is not really growth, and NPLs represent the amount of money that has been wasted.

In order correctly to identify NPLs we would need to include loans that might not technically be NPLs at current interest rates, but would be if interest rates were raised (by at least 400-600 basis points) to their “correct” level. Why? Because these loans are benefitting from the implicit annual debt forgiveness granted to them by household depositors – and the fact that they can pretend to be performing with the help of massive debt forgiveness should not change the fact that they are nonetheless un-repayable.

The combination of these two sources of GDP overstatement – uncounted environmental degradation and ignored NPLs – is pretty substantial. To show how substantial, assume that GDP has been overstated by anywhere from 2 to 4 percentage points over the past ten to fifteen years. This would imply that China’s GDP today is actually about 55% to 85% of its stated size – or to put it another way, that China’s economy is anywhere from 15% to 45% smaller than we think.

This is a pretty big haircut. I have no idea what the correct deduction is (none of my numbers seem especially implausible), but even very rough ballpark numbers suggest that China’s GDP may be sharply overstated. At the very least they also suggest that all those breathless predictions about when China will have the world’s largest GDP may turn out to be as simple-minded as the same predictions made about the USSR in the 1960s or, perhaps a little more plausibly, about Japan in the 1980s. And for the same reasons: in each case we start from the assumption that the country’s real GDP, inflated as it is by misallocated environmental costs and overstated investment numbers, is much larger than it really is. Much, much larger.

By the way notice that if we discount GDP by 20-40%, the astonishingly low household consumption share of China’s GDP – 35% in 2009 – rises to 44-59% – still very low by global standards, but not quite as surreal. Could it be that much of China’s GDP really is overstated, and with it total savings too?

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About the Author

z-pettis Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is also Chief Strategist at Shenyin Wanguo Securities (HK). Pettis has an impressive work history on Wall Street, Latin America, Europe and Asia (see his blog China Financial Markets for a complete bio).

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  1. Frank Li says :

    Sensational title, ridiculous contents! (1) All the #s out of China, including GDP, could be questioned for accuracy (20+%), because the system is (still) very flawed, from politics to accounting. (2) Yes, environmental pollution is a huge problem over there. But to use (2) against (1)? Give me a break!!! Should we use obesity against the U.S. GDP?????

  2. admin (Member) Email says :

    Frank - - -

    Prof. Pettis has been living and working in China for the past decade. He is what I call "boots on the ground." We are well advised to give careful consideration to his observations.

    John Lounsbury

  3. Frank Li says :

    I like his writings in general, but not this one: It's so sub-standard!

    What an interesting world! Prof. Pettis, an American living in China, writes about China, while I, a China-born Chinese-American, live in the U.S. to write about America!

  4. Manaki says :

    There are plenty of national accounting violations by China and if you disagree with this article then listen to data that shows that almost an million die of pollution every year in China. Its like they are fighting and losing an war. Also Mr Li described China's gross domestic product figure as "man-made" and "therefore unreliable". You know who he is? He is believed China's next prime minister and is currently the country's executive vice premier. It is an openly known secret that heads of states show inflated and imaginary figure to increase their standings.



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