China to push aside Japan as No. 2 economy

NEW YORK (CNNMoney.com) -- China is likely to soon overtake Japan to become the world's second largest economy, a milestone that will only fuel growing fears about the economic might of the world's largest country.

China's economy grew by 8.7% in 2009, even in the face of a global economic slowdown. Japan, which will report its full-year numbers on Feb. 14, is expected to slip behind China due to the steep decline in its economy in the first half of last year.

Both China and Japan are likely to end the year with a gross domestic product, the broadest measure of economic activity, of just over $5 trillion. To put that in context, that's only a little more than a third of the size of the U.S. economy.

But with its huge population edge on the United States, many economists believe it is inevitable that China will eventually overtake the United States -- even if it takes another 20 or 30 years.

"It's kind of like the U.S. and Great Britain 125 years ago. Given how much larger we were, it was only a matter of time before we caught them," said Jay Bryson, global economist for Wells Fargo Securities. "And it's only a matter of time before they catch us."

But there are still many limitations on China's growth prospects. For those who are scared that the U.S. will fall behind its Chinese rivals sooner rather than later, it's useful to think back a bit more than 20 years, when Japan was considered a similar threat to U.S. economic dominance.

John Makin, a visiting scholar specializing in Asian economies at the American Enterprise Institute, pointed out that in the late 1980s, Japan was "viewed as the unstoppable force."

Since then the Japanese economy has struggled mightily, suffering through the so-called "Lost Decade" of economic decline followed by a period of only weak growth after that.

Of course, there are differences between Japan in the late 1980s and China today. Most notably, Japan was already a fully developed economy two decades ago.

China is still an emerging economy, feeding off the growth that comes from massive public works projects designed to catch-up to the infrastructure already found in the United States, Europe and Japan, as well as consumers entering the middle class eager to buy their first car or household appliance.

Echoes of Japan's problems. But there are plenty of similarities as well.

There are signs of a developing asset bubble in China's housing and equity markets. China's banking system has been dogged by questions about its transparency. There is also a dependence on exports that are supported by the government's manipulation of the currency and limits on population growth.

All were factors in Japan's troubles over of the last two decades.

The last year shows one of the problems with a country whose economy is greatly export driven. When the global recession hit, China's exports were not spared, and it took about $586 billion in government spending, to fill the gap.

That turned out to be a much bigger share of China's GDP than all the various bailouts and stimulus packages in the United States.

Lakshman Achuthan, managing director of Economic Cycle Research Institute, said China's exports, driven by its cheap currency, makes it vulnerable to even lower-cost developing economies.

"A 'Lost Decade' is not an immediate issue for China, but they need to shift away from export dependence," he said.

Adding to these risks is the obvious fact that China is still a communist country where the government, rather than free markets, makes many decisions on the allocation of capital and resources. The free flow of information is also limited.

Most Western economists would argue that this it not conducive to long-term economic growth, even if government control of economic decisions can help to boost output in the short-term.

"It's a bit like a very powerful but inefficient engine," said Makin. "They need to develop a way to allocate resources and capital that's not driven by not a bunch of central planners."