Economic Research:

Is China's Economy Really Besting Japan's? A Look Beyond GDP

Credit Market Services: Paul F Gruenwald, Chief Economist, Asia-Pacific, Singapore (65) 6216 1084; paul.gruenwald@standardandpoors.com Vincent R Conti, Economist, Asia-Pacific, Singapore (65) 6216 1188; vincent.conti@standardandpoors.com

Table Of Contents
GDP: Size Matters, But Export Growth And Product Sophistication International Investment Position And Direct Investment Flows Financial Sector Size And Development Physical Infrastructure Moving Beyond Headline GDP Notes:

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Economic Research:

Is China's Economy Really Besting Japan's? A Look Beyond GDP

When China's GDP passed that of Japan, the implication was that the country had taken on the mantle of economic leadership in Asia. China is now the world's second-largest economy, and the Organization for Economic Cooperation and Development (OECD) projects that it will overtake the U.S. by the end of this decade (see note 1). However, Standard & Poor's Ratings Services believes that this oft-quoted economic barometer may not provide an accurateor at least a completepicture of China's and Japan's relative economic strengths. China still lags Japan in many quantitative and qualitative indicators of development. That said, China is closing in on Japan in many areas, and it's doing so quickly in some, including the sophistication of its export products. Nevertheless, the gaps remain obvious--especially in institutions and the business environment--which could become an impediment for growth in China as the country shifts away from a heavy reliance on investment toward a consumption- and service-based economy. Overview The presumed mantle of economic leadership in Asia has passed from Japan to China, with the latter now firmly ensconced as the No. 2 economy in the world. However, when we examine metrics other than the level of GDP, China still lags Japan in many areas, sometimes by a sizable margin--although it is catching up. China also has more ground to gain with softer indicators, such as the strength of its institutions and the business environment, where the gap with Japan is larger.

GDP: Size Matters, But

Exactly when China became the world's second-largest economy depends on which measure one uses. In nominal U.S. dollar terms, China's GDP surpassed Japan's in 2010. However, when measured in terms of purchasing power parity (PPP, or the exchange rate that reflects relative prices in two economies for the same basket of goods, which allows better international comparisons), China's GDP passed Japan's in 2002. Moreover, as of 2013, China's GDP was over 2.8x larger than Japan's on a PPP basis, reflecting China's relatively fast growth over this period. China's GDP on this measure is now three-quarters of the U.S. level. China's rise is equally impressive on a global scale. Its share of global GDP (in PPP terms) climbed to 15.5% in 2013 from a paltry 2.2% in 1980. Japan has moved in the opposite direction, though more gradually, slipping to 5.5% of global output last year from 8.8% in 1980. Regional comparisons are even more dramatic: China's share of Asia-Pacific GDP soared to 43.4% from 11.3% over 1980-2013. Japan's decline was almost the mirror opposite, falling to 15.3% from 45.6% in the same period.

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Economic Research: Is China's Economy Really Besting Japan's? A Look Beyond GDP

But is nominal GDP the best measure of economic success? China has a huge population and therefore a labor force advantage over Japan, which boosts its GDP. If we examine per capita GDP, the picture changes dramatically: China still shows a meteoric rise over the past three decades, but still lags far behind Japan. As of 2013, China's per capita GDP was US$9,828, one-fourth of Japan's US$37,135 (see chart 1).
Chart 1

Export Growth And Product Sophistication

Like its GDP, China's exports have also surged. This has happened not only in value terms; exports have also been ascending the value chain. Our data series starts in 1984, when China's exports totaled US$39 billion, less than one-fifth of Japan's US$213 billion. By 2012, China's exports had reached US$2.9 trillion, far above Japan's US$1.2 trillion. The compound annual growth rate for Chinese exports over the 28 years was 16.6%, versus Japan's 6.4%. To measure qualitative progress in exports, we used the methodology of the United Nations Conference on Trade and Development (UNCTAD), which divides exports into low, middle, and high technology products, as well as primary (e.g., timber and mineral ores) and labor/resource intensive (such as wood handicrafts) products. Medium- and high-tech exports have consistently accounted for 70%-80% of Japan's total exports since 1984. China, on the other

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Economic Research: Is China's Economy Really Besting Japan's? A Look Beyond GDP

hand, clawed its way up rapidly from near zero in the mid-1980s to nearly 60% in the mid-2000s, where it continues to hover (see chart 2). Notably, the gap between the two has since remained steady, at about 15 percentage points over the past five years.
Chart 2

Two other measures show China's swift climb up the value chain in its export composition. First, primary exports such as rice, cotton, mineral ores and the like have slid to about 7% of China's total exports for the past five years from almost 30% in the late 1980s. Second, labor- and resource-intensive exports, such as leather, textiles, and pottery, which peaked at more than 45% of China's total exports in the early 1990s, have fallen to half of that share over the past five years. In Japan, primary exports and labor- and resource-intensive exports have each remained uniformly below 10% of total exports over the sample period.

International Investment Position And Direct Investment Flows

Japan and China both have substantial and positive international investment positions (IIPs) or financial claims on the rest of the world. These mainly reflect the accumulation of current account surpluses and their investment returns. According to data from the Bank of Japan, at the end of 2012, Japan had an IIP of almost US$8.3 trillion, or 175% of

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Economic Research: Is China's Economy Really Besting Japan's? A Look Beyond GDP

its nominal GDP. Data from the International Monetary Fund show that China's end-2012 IIP was US$5.2 trillion, or almost 40% of its GDP. So on this measure, Japan's external "war chest" remains much larger than China's. Moreover, the two countries invest their international assets quite differently. Japan's portfolio assets (bonds and equity claims) accounted for the largest chunk of its IIP, at 46%, while foreign reserves formed 16.5% and direct investment 13.5%. China's IIP composition was markedly different: Official reserves accounted for nearly two-thirds of the total, and the U.S. has been the largest recipient, with an estimated 50%-60% of China's reserves, although that has fallen steadily over the past decade from over 90%. China's foreign direct investment (companies investing directly abroad) was just under 10% of total IIP while portfolio investment was just below 5% (see note 2). In short, the private sector spurs Japanese financial outflows, while the public sector propels Chinese financial outflows. The destination of the two countries' outward direct investment (which, empirically, is closely linked to trade) differs markedly as well. This is most evident in the share of foreign direct investment (FDI) outflows to emerging Asia. Over 2008-2012, Japan allocated 29% of its total outward FDI to emerging Asia. In contrast, about 64% of China's outward FDI went to those economies. Moreover, the composition of investments within the region varies as well. China sent almost all of its FDI bound for emerging Asia to the Tiger economies of Hong Kong, Korea, Taiwan, and Singapore, while Japan's composition of outward FDI to emerging Asia is much more balanced.
Chart 3

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Economic Research: Is China's Economy Really Besting Japan's? A Look Beyond GDP

China's and Japan's FDI flows into each other are also vastly different. Japan's direct investments to China dwarf those flowing the other way. Japan allocated about 10% of its total FDI to China over the past five years, averaging US$9.3 billion annually. In contrast, China apportioned just 0.25% of its total FDI to Japan over the same period, averaging under US$10 million each year. If not FDI, what accounts for the largest cross-border financial flow from China to Japan? Tourism.

Financial Sector Size And Development

Japan's financial sector (as a percentage of GDP) is larger than China's for most metrics, including bank assets, bank and financial system deposits, and private credit. By the above metrics, Japan is in the global top 10, while China's rankings range from 15th to 40th. Japan's bond (private and public) market capitalization also scores higher than China's. In particular, Japan's public bond market capitalization is the largest in the world, at 208% of GDP in 2011. China outscores Japan only in stock market capitalization, ranking 17th globally (at 84% of GDP) compared with Japan's 24th, based on the World Economic Forum's Financial Development Index 2012. Japan ranked consistently among the top 10 in the World Economic Forum's Financial Development Index (see table 1). China only recently moved into the top half of the sample of 62 countries at No. 23. China scores highest in the nonbank services area--above Japan--with a boost from IPO and merger and acquisition activities. China is about equal with Japan in financial stability, owing to its currency regime, which heavily manages the yuan's level against the U.S. dollar, and its low sovereign debt risk. But Japan continues to have a large advantage in the "softer" environment categories for both institutions and businesses, significantly outperforming China in financial sector liberalization, legal and regulatory issues, taxes, infrastructure, human capital, and the cost of doing business.
Table 1

World Economic Forum's Financial Development Index 2012

Ranking out of 62 countries China Overall Institutional environment Business environment Financial stability Banking financial services Non-banking financial services Financial markets Financial access Source: World Economic Forum. 23 35 47 20 17 4 21 41 Japan 7 15 19 19 3 6 5 27

Japan also excels in innovation. The Bloomberg Global Innovation Index for 2013 showed that Japan had a considerable lead, at sixth place globally versus China's 29th position (see note 3). Japan was in the top 10 for patent activity, research and development intensity, and researcher concentration. China was also in the top 10 for patent activity, as well as for manufacturing capability and high-tech density, but lags Japan by a large margin in tertiary efficiency and productivity.

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Economic Research: Is China's Economy Really Besting Japan's? A Look Beyond GDP

Physical Infrastructure
Although it's widely known that China's economic model relies heavily on infrastructure growth, the country's infrastructure ranking continues to lag behind Japan's in most areas. The 2013 World Economic Forum's World Competitiveness Report ranks Japan ninth globally for infrastructure, while China comes in 48th (see table 2). Out of nine subcategories, Japan is in the top 10 in two areas (railroads and available airline seats) and the top 20 in three others. China had one top 10 score (available airline seats) and one other (railroad infrastructure quality, in which Japan was ranked first) in the top 20. Neither country scored well in mobile telephone subscriptions. China's score in the infrastructure quality sub-category was 74th, the middle of the sample, thus pulling down its overall score.
Table 2

World Economic Forum's Global Competitiveness Report 2013

Rank out of 148 countries China Overall infrastructure Quality of overall infrastructure Quality of roads Quality of railroad infrastructure Quality of port infrastructure Quality of air transport infrastructure Available airline seat km/week (millions) Quality of electricity supply Mobile telephone subscriptions/100 people Fixed telephone lines/100 people Source: World Economic Forum. 48 74 54 20 59 65 2 67 116 58 Japan 9 14 12 1 30 37 4 34 73 13

Moving Beyond Headline GDP

So there is more to the Asian financial leadership story than just the GDP level. China looks less imposing when using metrics scaled by GDP. And it still trails Japan on many of the "soft" metrics, including business environment and efficiency, which we believe will become increasingly important as the country moves away from relying on investments and manufacturing toward a more service-based economy with consumption-led growth. Improving competitiveness and maintaining high productivity in this phase of China's development will be critical for securing the buffers needed to help face the inevitable challenges associated with changing its growth model. This requires a continual push in reforms along the lines spelled out in the recent Third Plenum. Some of the measures from the Plenum aim at moving prices for industrial inputs (such as coal and water) toward market-determined levels, which should boost resource allocation, and improving the financial infrastructure. Although it's been a decade since China overtook Japan as Asia's largest economy, the implications of this shift in

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Economic Research: Is China's Economy Really Besting Japan's? A Look Beyond GDP

terms of economic leadership still are not entirely clear. Economic measures that are expressed as a percentage of China's GDP combined with the more qualitative metrics, paint a mixed picture--and one that's much more nuanced than the headline GDP story.

Notes:
(1) http://stats.oecd.org/Index.aspx?DataSetCode=EO93_LTB# (2) We do not report here on the "other investments" category. (3) http://www.bloomberg.com/slideshow/2013-02-01/50-most-innovative-countries.html#slide52

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