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By one key measure, China's economy is already the biggest

For 10 years, analysts have been arguing about how soon China will overtake the United States to become the world's largest economy.

Now Jim O'Neill, the Goldman Sachs economist who coined the term Brics - for the rapidly growing markets of Brazil, Russia, India and China - has weighed into the debate with a new prediction.

In the early years of the past decade, Goldman projected that China's economy would outstrip America's sometime around 2040. Since then, China's growth has surpassed all expectations, while the US has suffered crisis and recession.

As a result, O'Neill has updated his forecast. In a new book to be published next week, he writes that China could outpace the US 'as early as 2027 and perhaps even sooner'.

The yardstick he is using here is gross domestic product, or GDP. What O'Neill is saying is that in 16 years' time, China's total output of goods and services could equal or exceed that of the US in value.

But as Hong Kong-based independent economist Jim Walker has pointed out, if you look at another key measure - money supply - then China had already overtaken America as the world's largest economy two years ago. In this case, however, first place is nothing much to celebrate.

The indicator Walker is specifically looking at is M2 money supply, which is defined as the amount of money circulating in an economy in the form of notes, coins and bank deposits.

Thanks to the Federal Reserve's policy of quantitative easing, US money supply has grown rapidly since the 2008 collapse of Lehman Brothers. But as the chart shows, the growth of US money pales in comparison with the rate at which China's M2 has ballooned over the same period.

From some 16 per cent smaller than America's M2 immediately before Lehman's implosion, China's money supply had mushroomed to become 34 per cent bigger at the end of last month.

In an economy which is still less than half the size of the US in terms of output, such a rapid monetary expansion spells big trouble, warns Walker.

He argues that such massive growth in money and credit has severely distorted key price signals in China, largely because lending rates are artificially low.

In most countries, policymakers try to keep benchmark lending rates roughly in line with the nominal growth rate of the economy. In the US, for example, the prime lending rate deflated by nominal growth comes out at minus 0.7 per cent. In China, the equivalent lending rate works out at minus 10 per cent.

At such a low rate, says Walker, borrowing to invest is effectively without cost. That has led to a huge misallocation of resources into unproductive investments which drove up inflation in land, property and commodity markets.

The problem will come when policymakers try to wind back credit growth to prevent overheating. In an economy powered largely by investment, the sudden credit drought will precipitate an abrupt slowdown in growth.

That hasn't happened so far partly because China's shadow financial system has continued to expand rapidly even as the authorities have clamped down on credit growth through the formal banking system. As a result, overall credit growth has barely slowed over the past 12 months.

But Walker warns that a cyclical downswing looks inevitable over the next couple of years, leading to a 'hard landing' for the Chinese economy. And he means a really hard landing, with output actually contracting.

The good news is that Walker doesn't think this scenario will greatly damage China's long-term growth prospects. He still believes that China can manage average annual GDP growth of 5 to 7 per cent over the next couple of decades, so China is still on target to overtake the US at some point.

It's just that China's growth will be 'a lot bumpier' than anyone currently expects.

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