Gross Domestic Product (GDP) is one of the most widely used measures of an economy’s output or production. It is defined as the total value of goods and services produced within a country’s borders in a specific time period – monthly, quarterly or annually.

GDP is an accurate indication of an economy's size, while GDP per capita has a close correlation with the trend in living standards over time, and the GDP growth rate is probably the single best indicator of economic growth. As Nobel laureate Paul A. Samuelson and economist William Nordhaus put it, “While GDP and the rest of the national income accounts may seem to be arcane concepts, they are truly among the great inventions of the twentieth century.” Here’s why.

Why GDP is Important

Samuelson and Nordhaus neatly sum up the importance of the national accounts and GDP in their seminal textbook “Economics.” They liken the ability of GDP to give an overall picture of the state of the economy to that of a satellite in space that can survey the weather across an entire continent. GDP enables policymakers and central banks to judge whether the economy is contracting or expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation looms on the horizon.

The national income and product accounts (NIPA), which form the basis for measuring GDP, allow policymakers, economists and business to analyze the impact of such variables as monetary and fiscal policy, economic shocks such as a spike in oil price, as well as tax and spending plans, on the overall economy and on specific components of it. Along with better informed policies and institutions, national accounts have contributed to a significant reduction in the severity of business cycles since the end of world War II.

GDP Calculations

GDP can be calculated either through the expenditure approach (the sum total of what everyone in an economy spent over a particular period) or the income approach (the total of what everyone earned). Both should produce the same result. A third method – the value-added approach – is used to calculate GDP by industry.

Expenditure-based GDP produces both real (inflation-adjusted) and nominal values, while the calculation of income-based GDP is only carried out in nominal values. The expenditure approach is the more common one and is obtained by summing up total consumption, government spending, investment and net exports.

Thus, GDP = C + I + G + (X – M), where

C is private consumption or consumer spending;

I is business spending;

G is government spending;

X is exports, and

M is imports.

Why GDP Fluctuates

GDP fluctuates because of the business cycle. When the economy is booming and GDP is rising, there comes a point when inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads the central bank to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation. As interest rates rise, companies and consumers cut back their spending, and the economy slows down. Slowing demand leads companies to lay off employees, which further affects consumer confidence and demand. To break this vicious circle, the central bank eases monetary policy to stimulate economic growth and employment, until the economy is booming once again. Rinse and repeat.

Consumer spending is the biggest component of the economy, accounting for 70% of the U.S. economy. Consumer confidence, therefore, has a very significant bearing on economic growth. A high confidence level indicates that consumers are willing to spend, while a low confidence level reflects uncertainty about the future and an unwillingness to spend. Business investment is another critical component of GDP, since it increases productive capacity and boosts employment. Government spending assumes particular importance as a component of GDP when consumer spending and business investment both decline sharply, as, for instance, after a recession. Finally, a current account surplus boosts a nation’s GDP, since (X – M) is positive, while a chronic deficit is a drag on GDP.

Drawbacks

Some criticisms of GDP as a measure of economic output are:

  • It does not account for the underground economy – GDP relies on official data, so it does not take into account the extent of the underground economy, which can be significant in some nations.
  • It is an imperfect measure in some cases – Gross National Product (GNP), which measures output from the citizens and companies of a particular nation regardless of their location, is viewed as a better measure of output than GDP in some cases. For instance, GDP does not take into account profits earned in a nation by overseas companies that are remitted back to foreign investors. This can overstate a country's actual economic output. For example, Ireland had GDP of $210.3 billion and GNP of $164.6 billion in 2012, the difference of $45.7 billion (or 21.7% of GDP) largely being due to profit repatriation by foreign companies based in Ireland.
  • It emphasizes economic output without considering economic well-being – GDP growth alone cannot measure a nation's development or its citizens' well-being. For example, a nation may be experiencing rapid GDP growth, but this may impose significant cost to society in terms of environmental impact and increase in income disparity.
Global GDP Growth Trends

Discussions about GDP growth invariably turn to the torrid pace of growth recorded by China since the late 1970s and India from the 1990s, following economic reforms that revitalized the Asian giants. Smaller nations like the Asian Tigers – Hong Kong, Singapore, South Korea and Taiwan – had already achieved rapid economic growth from the 1960s onward by becoming export dynamos and focusing on their competitive strengths. But China and India succeeded despite their massive populations, as an average 10% GDP growth rate in China since 1978 and a slower growth pace in India enabled hundreds of millions to escape the clutches of poverty.

While the emerging market and developing nations have been growing at a faster pace than the developed world since the 1990s (Table 1), the divergence in growth rates has become marked since the end of the Great Recession in early 2009. In 2011, for instance, developing countries collectively recorded GDP growth of 6.2%, while the developed nations only grew 1.7%. For 2014, the former are forecasted to grow by 5.1%, compared with 2.0% for the latter. While the growth gap is expected to contract, it remains significant nevertheless.

Table 1: Average Annual GDP Growth for Select Nations

1990 – 2000

2000 – 2012

China

10.6%

10.6%

India

6.0%

7.7%

U.S.

3.6%

1.6%

Germany

1.6%

1.1%

Japan

1.0%

0.7%

Source: World Bank – World Development Indicators

Future GDP Shifts

The Organization for Economic Cooperation and Development (OECD), in a report released in November 2012, forecasts major shifts in global GDP by the year 2060. The report said that based on 2005 purchasing power parity (PPP) values, China would have GDP of $15.26 trillion by 2016, exceeding the United States’ GDP of $15.24 trillion for the first time and becoming the world’s largest economy. The Chinese economy is forecast to be 1.5 times larger than the U.S. by 2030 and 1.7 times bigger by 2060. India is also expected to overtake the U.S. economy to become the second-biggest in 2051. The report also forecasts that the combined GDP of China and India will exceed that of the combined G-7 nations (the world’s richest economies) by 2025, and be 1.5 times larger by 2060.

But can one extrapolate the remarkable growth rates of the Asian giants indefinitely into the future? In a report released in November 2013, former U.S. Treasury secretary Lawrence Summers and Harvard economist Lant Pritchett questioned this assumption, dubbing the tendency to think that China and India could grow rapidly for an indefinite period as “Asiaphoria.” Summers and Pritchett noted that if China and India continue to grow briskly until 2033, their combined GDP would be $56 trillion, whereas if they slow down to the world average, their combined GDP would be about $12 trillion to $15.5 trillion, which is about one-fourth that of the rapid-growth scenario.

But even if their growth rates slow down, thanks to their sheer size, China and India appear to be inexorably on track to become the world’s biggest economies in time. The largest and best-run companies in these countries will be among the biggest beneficiaries of long-term economic expansion. An investor wishing to participate in these growth prospects can easily do so through exchange traded funds like the iShares FTSE China Large-Cap ETF (NYSE:FXI), which tracks the performance of 26 of the largest Chinese companies like China Mobile, China Construction Bank, Tencent Holdings and PetroChina. Or the venerable India Fund (NYSE:IFN), a closed-end fund that was introduced in February 1994 and holds some of the subcontinent’s best-known companies such as HDFC, Infosys, Tata Consultancy Services, ITC, ICICI Bank and Hindustan Unilever.

Using GDP data

Most nations release GDP data every month and quarter. In the U.S., the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends, and a final release three months after the quarter ends. The BEA releases are exhaustive and contain a wealth of detail, enabling economists and investors to obtain information and insights on various aspects of the economy.

GDP data's market impact is generally limited, since it is “backward looking,” and a substantial amount of time has already elapsed between the quarter end and GDP data release. However, GDP data can have an impact on markets if the actual numbers differ considerably from expectations. For example, the S&P 500 had its biggest decline in two months on Nov. 7, 2013, on reports that U.S. GDP increased at a 2.8% annualized rate in Q3, compared with economists’ estimate of 2%. The data fueled speculation that the stronger economy could lead the Federal Reserve to scale back its massive stimulus program that was in effect at the time.

One interesting metric that investors can use to get some sense of the valuation of an equity market is the ratio of total market capitalization to GDP, expressed as a percentage. The closest equivalent to this in terms of stock valuation is market cap to total sales (or revenues), which in per-share terms is the well-known price-to-sales ratio. Just as stocks in different sectors trade at widely divergent price-to-sales ratios, different nations trade at market-cap-to-GDP ratios that are literally all over the map. For example, the U.S. had a market-cap-to-GDP ratio of 120% as of end-Q3 in 2013, while China had a ratio of just over 41% and Hong Kong had a ratio of over 1300% as of end-2012.

However, the utility of this ratio lies in comparing it to historical norms for a particular nation. As an example, the U.S. had a market-cap-to-GDP ratio of 130% at the end of 2006, which had dropped to 75% by the end of 2008. In retrospect, these represented zones of substantial overvaluation and undervaluation, respectively, for U.S. equities.

The Bottom Line

In terms of its ability to convey information about the economy in one number, few data points can match the GDP and its growth rate.



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