China Could Pass the U.S. as the World's Largest Economy This Year. So What?

The United States has held the title of the world's largest economy for more than a century, presiding over the growth of emerging nations and developing markets around the globe. That economic leadership may end in 2014.

China's economic growth over the past few decades has astounded economists and analysts, and despite its size, Asia's largest economy posted double-digit-percentage annualized growth even into the 21st century. While China's economy has slowed in the second decade of the century, the World Bank still estimates the country will achieve 7.5% growth this year -- far more than the 2.8% annual growth the organization expects from the U.S.

Many economists expect China to eclipse the U.S. as the world's largest economy sometime in the next few decades, but new World Bank data suggests that the transition could come much sooner. Is China ready now to assume its spot as the world's No. 1 economy? If so, what does it mean for the U.S., investors, and you?

What does the "largest economy" mean?
With a population of more than 1 billion, China seems poised to ride its demographics and modernization to the top of the world's economic leaderboards in the near future. The country's urbanization has recently spurred a massive growth of cities and a boost to the middle class. Booming populations in metropolises like Shanghai and Guangzhou have been major drivers in shifting China's labor force and economy away from agriculture and toward industry and services, competing for local market share with international giants. China's embrace of the global economy has brought it right behind the U.S.' top-ranked economy.

Skyline of Pudong, Shanghai in 2005. Source: Wikimedia Commons.

And the changing of the guard could come much sooner than expected. The World Bank recently released the data from its International Comparison Program, a 2011 study that sized up the world's national economies based on purchasing power parity, or PPP, an estimate that adjusts for buying power and costs across global markets and currencies. Based on the data, the World Bank said that if China's economy meets growth expectations for 2014, it could surpass the U.S. economy as the world's largest this year.

It's part of a dramatic rise among emerging markets that have risen to join the largest economies in the world. The World Bank projects that China's economy was 87% the size of the U.S. economy in 2011, while both India and Russia have entered the organization's ranking of the largest six economies based on PPP estimates. Meanwhile, former leaders such as Germany, the U.K., and Japan have slipped as growth has slowed and birthrates have fallen. In total, China posted gross domestic product of just under $13.5 trillion in 2011, $2 trillion behind the U.S. GDP for the year, according to the World Bank. Both countries' economies were more than double the size of third-ranked India.

However, the World Bank's data doesn't tell the full story. Accounting for the world's economies on a nominal scale based on exchange rates, the organization estimated China's economy at a little more than $7.3 trillion in 2011 -- far smaller than the U.S. economy. So is China really ready to assume the mantle of No. 1? First the country will have to figure out a number of issues dragging on its aspirations -- ones that could also thwart the ambitions of eager investors hoping to cash in on this growth story.

The hidden problems in China's rise
International investment and net trade surpluses have fueled many an emerging market's rise, and none more so than China's. However, investors have recently pulled money from the emerging markets back to the U.S. and Europe, which has led to a jarring halt in stocks around emerging markets. Hong Kong's Hang Seng Index (HSIINDICES: ^HSI  ) has fallen more than 2% over the past year, and numerous big-name Chinese stocks have slumped on the investment drought. The Hang Seng has even trailed markets around Asia and the world, reaching less than half of the gains that the S&P 500 enjoyed over the past five years.

^HSI Chart

^HSI data by YCharts.

China will need to drive domestic consumption higher if it wants to sustain its global rise, but that's easier said than done. The country's population still has a long way to go to catch up with leading economies. While China's overall economy may be among the world's largest, the World Bank measured its per-capita GDP at roughly $10,000 in 2011 -- just over 20% the size of the U.S.' per-capita GDP of $49,800 and less than all but a handful of European nations. China accounted for 14.9% of the world's economy that year despite having nearly 20% of the global population; by contrast, the U.S. made up more than 17% of the world's economy on a PPP basis despite harboring just 4.6% of the world's people.

Expect that gulf to shrink as China's urban population continues to grow in the coming years, but that trend will meet its own challenges. Housing costs have spiraled higher in some of the country's biggest cities, with the bubble cramping the ability for many urban Chinese to spend more. While housing prices have slowed somewhat in the early months of 2014, home sales have dropped off by steeper declines. This comes as costs are on the rise across China: The International Monetary Fund estimated in its 2014 World Economic Outlook that consumer prices will climb 3% in China, double the 1.5% expected in the U.S. That will crunch Chinese consumers' flexibility even more in the coming years, and if Beijing will need to counter by turning around shortfalls in critical measures for a modern economy.

China lags behind in certain measures of technological prowess and innovation, crucial edges that have helped the U.S. maintain its economic leadership into the 21st century. If Chinese innovation can't step up, domestic companies will have a whale of a challenge making the most of the economy's rise to No. 1.

And rather than helping the U.S., China's failure to live up to its economic rise would mean a huge lost opportunity for American companies and investors in the world's most promising opportunity.

Can companies and investors make the most of China's potential?
While many see global rankings such as the largest economy as a point of national pride, the reality of today's global economy is that we're all in this together. China's rise has meant huge profits for top American companies, and if Beijing can't confront its huge hurdles, the world will lose out on the rewards that could have been.

GM's Chevy Volt in China. Source: GM China Photo Gallery.

Perhaps no greater example exists than General Motors (NYSE: GM  ) . This auto stock has roared 48% higher over the past two years in large part due to China, which has emerged as GM's largest market. The company posted 13% sales growth in China in its most recent quarter -- a far cry from the 2% sales drop it saw in North America. If GM wants to keep up, it will need to harness the power of China's urban movement and the rising middle class's need for transportation. German rival Volkswagen  (NASDAQOTH: VLKAY  )  has harnessed the same demographic power. The stock has surged more than 36% over the past year as Volkswagen turned China, also its largest market, into a haven of growth and investor windfall by generating 15% sales growth and record operating profit in the country in its most recent quarter.

Of course, global household names aren't the only ones capitalizing on China's growth: Savvy investors have turned to emerging markets' own companies in order to advantage of their rising economies, and the recent slowdown in some of these markets has dealt a big blow. Take Baidu (NASDAQ: BIDU  ) : Perhaps no other Chinese company is better positioned to capitalize the trends in urban and middle-class growth than this Internet search colossus, which holds a 60% market share in China's search industry. Analysts expect double-digit percentage revenue growth from Baidu in the next two years, and as more Chinese citizens assimilate the Internet into their daily lives, shareholders are in prime position to reap long-term gains.

The opportunity is immense for corporations and investors alike. China simply has to follow through on its potential.

Challenges abound
China may be ready to move into pole position as the world's largest economy, according to the World Bank's most recent estimate, but that doesn't mean this rising giant is ready to reign just yet. From an innovation shortfall to rising costs and the housing bubble, China faces an abundance of challenges. While savvy long-term investors have turned toward emerging markets as a huge growth opportunity, this up-and-coming economic leader is no sure bet despite its potential. The best investors know to buy into the best companies, regardless of the trends at work -- and with China in transition from emerging market to fully emerged leader, every investor needs to watch this growing economy with both eyes wide open in the coming years.

Will this under-the-radar opportunity make your portfolio number one in 2014?
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