"American political and military leaders are amplifying flawed estimates that China’s annual defense spending is much higher than it actually is. In these mistaken calculations, China’s defense spending has reached $700 billion, approaching the level of the U.S. defense budget. These exaggerated estimates have gained traction in Congress, the media, and defense circles.

However, as we show in our recent article in the Texas National Security Review (and as we also discussed on Horns of a Dilemma) these exaggerated estimates count spending categories for China without counting similar spending for the United States and apply purchasing power parity methods emphasizing low labor costs as a key military advantage. PPP exchange rate estimates address a problem familiar to many international travelers: a dollar spent in a poorer country will buy more of a domestic product like clothing, food, or housing than a dollar spent in a richer country. Higher overall price levels in richer countries are due to higher levels of technology investment, productivity, and wages. Purchasing power parity adjusts for different price levels to allow cost comparison for similar products.

Accounting for spending not included in official budgets and using new World Bank purchasing power parity data published in 2024, we estimate that China will spend the equivalent of $474 billion on defense in 2024, much more than its official 2024 defense budget of $232 billion at market exchange rates. When compared to similar U.S. spending categories, this represents 36 percent of 2024 U.S. defense-related spending of $1.3 trillion.

Our approach is based on two simple but frequently ignored principles. First, any comparison to U.S. defense spending should contain similar spending categories for China and for the United States. Second, the exchange rate employed for converting currencies should be appropriate to the military budget. If purchasing power parity adjustments are made for specific budget elements such as military wages, then they should, where possible, be based on actual cost data (not estimates). Where this is more difficult, appropriate sector-level purchasing power parity data should be applied to inputs such as personnel, operations and training, and equipment costs.

Why do such estimates matter, and why is it important to make them as accurately as possible? First, there is no excuse for getting an important national security–related estimate wrong when better data and methods are available. Second, defense spending estimates play a critical role in assessing the degree and nature of military challenges that China poses to the United States and its allies. All else equal, a larger defense budget suggests a more salient threat. Underestimating the threat can leave one unprepared, while overestimating it can fuel spirals of security competition. Third, a misplaced focus on aggregate spending levels can distract attention from the more important debate about what kinds of capabilities the United States should purchase in response to China’s ongoing military modernization.

Creating a Military Purchasing Power Parity

There are a number of reasonable ways to compare U.S. and Chinese defense spending, but no analytically defensible approach would produce a number that shows China rapidly catching up to or on the cusp of surpassing U.S. total comparable defense spending, as the $700 billion estimate is purported to show. Among the problems with estimates that produce such high figures is the inclusion of spending categories beyond the official defense budget for China without including the same categories of defense-related spending for the United States, such as domestic security, benefits to veterans, defense-related research and development not in the official defense budget, and “civil-military fusion” (the fusing of commercial and defense-related spending on technologies such as semiconductors and artificial intelligence).

Additional errors come with the use of purchasing power parity exchange rates. Importantly, purchasing power estimates have limitations. For example, they were not developed to measure internationally tradable goods, services, and technologies. Instead, market exchange rates better reflect purchasing power for these goods.

Using the market exchange rate to convert Chinese defense spending to equivalent dollars may be the best choice because it more accurately reflects the cost of advanced weapons and equipment, and it is less prone to calculation error. However, market exchange rates can understate purchasing power for some types of defense spending in a country like China. In a developing economy, wages, clothing, food, and construction will be based on labor-intensive costs. If purchasing power parity is used, however, careful consideration must be given to how the adjustments relate to real-world inputs and outputs. Purchasing power adjustments in labor-intensive sectors will show a significant purchasing power advantage for China.

However, purchasing power parity exchange rates can also reflect lower relative purchasing power than market exchange rates for capital- and technology-intensive goods. World Bank figures show that China’s purchasing power for machinery and equipment technology is significantly less than the purchasing power implied by the market exchange rate. In other words, certain technologies are more costly for China to acquire than they would be for the United States to acquire. This can occur where there are trade barriers for such goods, or where the cost of barriers to entry or learning curves must be overcome. Any purchasing power parity exchange rate used should correspond — within reasonable bounds — to the spending category under consideration. The World Bank’s methodological guidelines and methods should be followed to ensure that the defense-related goods under consideration are comparable."

--Taylor Fravel, George Gilboy, and Eric Heginbotham 

[To read the full commentary]

September 2, 2024 | War on the Rocks (WOTR), Texas National Security Review