The best way to profit from China's potential

China now looks set to become the world's second biggest economy this year, ahead of Japan.

Japan's nominal GDP for the second quarter came in at $1.288 trillion. That compares to $1.337 trillion for China. The process has been helped by the fact that Japan's economy slowed by more than expected in the second quarter.

Of course, this might be a very visible, headline-grabbing milestone. But in economic terms, it doesn't mean a great deal. China's rise has been on the cards for a long time.

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What we really want to know is, what happens now? Can China just keep on growing, or is it heading for a nasty fall? And whatever happens, how can you profit from it?

Why China is happy to be seen as a developing country

China's position as the world's second-largest economy isn't an especially big deal in economic terms. As many pundits point out, the economy overtook Japan's a long time ago based on alternative measures. And I'm sure you could debate the details of the data. No doubt various future revisions could move the goalposts in one direction or another.

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But it does add to the sense that China is the unstoppable dominant force of the future. Goldman Sachs reckons China will overtake the US by 2027. Accountancy group PricewaterhouseCoopers reckons it'll be more like 2020.

The trouble is, it's not as simple as just looking at the growing GDP figure. Take just one obvious point. China might be a huge economy collectively. But its individual citizens are still poor by Western standards. GDP per head comes in at around $3,600. That's about a tenth of Japan's GDP per head.

So you can see why the Chinese government isn't necessarily keen to embrace its role as a would-be superpower. When you're seen as just another developing country, you can get away with ignoring tough questions about your currency controls, or your role in curbing global greenhouse gas emissions.

And I can't say I blame them. Pundits may urge China to "accept the responsibilities that come with being a leading economic power", as one puts it in the FT. But China's got bigger domestic problems to worry about.

Bloomberg quotes Ma Jiantang, head of China's statistics bureau: "China has a large population, a weak economic foundation, relatively few resources and a large poverty population, which remains our basic situation." That's a nice summary of the issues involved.

The FT adds some extra detail from Yi Xianrong of the Finance Institute at the Chinese Academy of Social Sciences, a state-backed think tank. "Since 2003, China's economic growth has relied on two pillars: exports and real estate."

Exports have "brought some benefits in terms of modernisation." But the property market's growth "is based on mismanagement of land resources and property speculation, leading to skyrocketing house prices and a real estate bubble that must eventually be deflated."

Now as my colleague Cris Sholto Heaton points out inMoneyWeek Asia this week(China is slowing down - what will the government do about it?), China's breakneck growth is already slowing down. And the government has been trying to tackle the property bubble.

A slump in the Chinese economy would hurt markets worldwide

But of course, when you're trying to slow an economy down, the big worry is that you go too far. A property crash would definitely hurt the banking system. It might not derail the whole economy, but it's definitely a potential source of some very nasty future surprises.

And not just for China. Now that we're all fixated on the country's growth, any sign of a serious slump would hit markets around the world.

China could well face a hard landing. At the same time, you can't grow a world-beating economy and not expect to encounter a few potholes along the road. And it would take a very serious collapse indeed to unwind all the progress that China has already made.

How to profit from China's potential

Both Cris, and Paul Hill in his Precision Guided Investments newsletter, reckon that China will adapt one way or another - it has to. In fact, Paul reckons that China's "reinvention as a consumer-driven economy" will be "one of the biggest investment trends of the 21st century."

Basically, the country needs to try to move away from its dependence on Western consumers. And there's no better way to do that than to create its own consumer class. This is partly what's enabled recent wage hikes at factories across China's industrialised zones, reckons Paul.

Better yet, says Paul, is that you don't have to invest in Chinese stocks to take advantage. By investing in Western-listed companies with heavy emerging market exposure, you get the benefit of China's growth without the same level of risk.

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