The United States has been the world’s biggest economy since 1871, but that top ranking is now under threat from China. The Asian giant has achieved economic growth averaging 10% since it initiated market reforms in 1978 and, in the process, lifting almost half of its 1.3 billion population out of poverty and becoming the undisputed second-largest economy. China’s gross domestic product (GDP) – in terms of current prices and market exchange rates – was estimated by the IMF at approximately $8.25 trillion in 2012, which is just over 50% of US GDP of approximately $16 trillion for the same year. While that is a significant gap that may take China many years to close, using another measure known as Purchasing Power Parity (PPP), China is forecast to race past the U.S. in just a few more years.
 
PPP and Its Relevance
PPP is essentially the implied exchange rate at which the currency of one country would have to be converted into that of another country to buy an identical basket of goods and services in each country. One of the best-known examples of PPP is the “Big Mac” index, published by the Economist magazine, which calculates simplified PPP exchange rates based on the popular McDonald’s sandwich. The biggest advantages of PPP exchange rates is that they have greater stability over time as compared to more volatile market exchange rates, and they provide a better estimate of consumers’ purchasing power in developing nations.
 
When Will China Surpass the U.S.?
In November 2012, the Organization for Economic Cooperation and Development (OECD) published an authoritative study on global long-term growth prospects. The study concluded that on the basis of 2005 PPP rates, China may surpass the Euro area’s GDP within a year, and that of the U.S. in another few years to become the world’s largest economy.
 
Specifically, China’s GDP (based on 2005 PPP) is forecast by the OECD at $15.26 trillion for 2016, exceeding the forecasted U.S. GDP of $15.24 trillion for the very first time. China is estimated to pull ahead of the U.S. steadily in the following years; the Chinese economy is estimated to be 1.5 times as large as the U.S. by 2030 and 1.7 times bigger by 2060. India, for its part, is only projected to surpass the U.S. in 2051, when its GDP is forecast at $33.1 trillion, compared with U.S. GDP of $33 trillion. The IMF reached a similar conclusion in its October 2012 World Economic Outlook report, projecting that China’s GDP of $20.20 trillion in 2017 (based on current, rather than 2005, PPP rates) will exceed U.S. GDP of $19.75 trillion for the first time.

Will It Even Matter?
Only for bragging rights! With a population less than one-fourth that of China, the U.S. is still projected to remain one of the world’s most prosperous economies by 2060. The OECD study forecasts U.S. per capita GDP or income to more than double over the next 50 years, from roughly $43,000 in 2012 (based on 2005 PPP rates) to $92,000 in 2060. China is forecast to boost its per capita income by a stunning seven-fold over this period, from $8,000 in 2012 to $55,000 by 2060. The difference in income levels between China and the U.S. are estimated to narrow substantially as a result. While 2012 per capita incomes in the U.S. were more than five times higher than in China, by 2060, they would only be 67% higher.
 
How Will the U.S. Cope?
The U.S. will undoubtedly continue to be one of the world’s most important economies for the foreseeable future. The World Economic Forum ranked the U.S. economy seventh out of 144 countries in its 2012-13 Global Competitiveness Report. Although the U.S. has slipped in terms of competitiveness in recent years, it remains one of the most dynamic economies thanks to the innovation of its companies, strong R&D, excellent university system and flexible labor markets. China is ranked 29th, with the WEF noting some deterioration in areas that have become critical for its competitiveness, such as financial market development, technological readiness and market efficiency. Growth isn’t always a great thing, with rapid economic growth over more than three decades leaving China grappling with a host of problems including income inequality, rapid urbanization, environmental issues and demographic pressures due to the aging population.

How Can You Play this Megatrend?
With the countries having grown exponentially over the past decade, investor enthusiasm about the growth prospects for China and India is nothing new. So how can an investor play this megatrend of China, and to a lesser extent India, becoming the world’s biggest economies? As GDP expands, the best-run companies in these countries should also grow. The easiest way for an investor to participate in such long-term growth is either though exchange traded funds (ETFs) or country funds. One such example is the iShares FTSE China 25 Index Fund (ARCA:FXI), which represents the performance of the 25 largest Chinese companies such as China Mobile and PetroChina. Another example is the closed-end India Fund (NYSE:IFN), which has been in existence since 1994 and holds Indian blue-chips including HDFC, ICICI Bank, Tata Consultancy Services and Infosys.
 
The Bottom Line
While the Chinese economy may be poised to surpass the U.S. on a PPP basis in less than five years, the U.S. will continue to be well ahead on most indicators related to living standards and quality of life. However, China’s surging economic clout may result in the country increasingly challenging the U.S. on a number of fronts, including diplomacy and military.

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