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The China conundrum

The inexorable rise of China has been dependent on exports but demand is falling off with Western economies struggling

GDP figures for the second quarter show that China has ousted Japan as the world’s second-biggest economy.

Nominal GDP in China in Q2 was $1.34trn, compared with $1.29trn for Japan, and it looks likely that China will also be ahead when full-year figures for 2010 come in early in 2011. In 2009, Chinese GDP was $4.9trn versus $5.1trn for Japan. Although the US is still comfortably the world’s biggest economy, with 2009 GDP of $14.3trn, China is widely expected to overtake the US by 2030.

The past decade has seen significant change in the world’s economic power base, with both China and India overtaking Germany and the UK, for many years the third and fourth-biggest economies, on a purchasing power parity basis. Brazil and Russia, the other two Bric countries, are closing in fast.

But the bald figures are not the only important gauge. Japan has been stagnating for 20 years while China has been averaging annual GDP growth rates of around 8 per cent for several decades.

In spite of their geographical proximity, China and Japan are very different creatures – the one a vast land mass and the world’s most populous nation; the other an archipelago with a population smaller than that of Nigeria.

Yet China’s development in recent years resembles Japan’s post-war economic miracle. China has followed a model of export-driven growth as well as building out infrastructure in order to spur the phenomenal growth seen in the past 30 years. A similar model was adopted in Japan after the war.

But Japan’s boom years from the 1950s have been followed by two decades of difficult conditions. Japan was the high-growth area until the bubble burst in the late 1980s. It became a pre-eminent economic power, had the biggest stockmarket capitalisation in the world, the most expensive stock of real estate and so on, but the bubble burst spectacularly and the economy now languishes with periodic bouts of deflation, interest rates have been close to zero for more than a decade, government debt/GDP is at extremely high levels, the population is ageing, domestic demand is deficient and the country is highly dependent on exogenous factors to drive growth.

China’s stockmarket capitalisation may well also surpass that of Japan. This has happened before, in both 2008 and 2009 but, at present levels, there is about a 10 per cent gap between the overall market value of Japanese and Chinese stocks.

However, the future is not without risks for China, and hence for the rest of the world, for which China’s economic ascendancy has been a significant source of growth.

The current state of the world, with heavily indebted Western nations, risks to global growth (and Chinese export markets) and a need to prevent domestic overheating and overcapacity by renewed infrastructure spending, poses significant challenges to the Chinese authorities.

Growth needs to be rebalanced towards domestic consumption and authorities face a difficult balancing act to ensure sufficient external momentum, without triggering trade disputes, while looking to inject improved momentum to consumers.

However, domestic consumption growth may be hard to achieve in a country that is ranked 128th in the world – one place above Namibia – in GDP per capita terms.

China’s share of domestic consumption to GDP stands at around half to two-thirds that of developed economies and has actually been on a declining trend. The key will be how China adapts to an environment where reliance on developed economies to fuel exports will be significantly less than in the past and where consumption growth will have to, for the first time, outstrip growth in the broader economy.

Paul Niven is head of asset allocation at F&C Investments

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