Now the No. 2 Economy, What's Ahead for China?

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The Chinese economy is now larger than Japan's -- a symbolic development that also signals a strategic shift in Asia's power balance. China's gross domestic product is now $1.335 trillion, surpassing Japan's GDP of $1.286 trillion, which isn't adjusted for price and seasonal variations, according to the Associated Press.

What's the significance of this news, and what might it mean for China? To get some insight on the economic and strategic implications, DailyFinance spoke to Evan A. Feigenbaum, director of geopolitical consultancy Eurasia Group's Asia practice -- and a former deputy assistant secretary of state for South Asia at the U.S. State Department from 2007 to 2009. Feigenbaum notes that on one level nothing much has changed now that China is officially the world's second-largest economy. But on another level, this development cements critical changes that have been building both within China and regarding China's foreign relations, particularly with the U.S.

DailyFinance: How big of a deal is the fact that China's economy is now larger than Japan's?
Evan Feigenbaum: It's of huge significance and of no significance at all. It's hugely significant because it shows how very important China has become in the region. For a long time, the country has been on track to surpass Japan, and now it's finally happened. Not only is China lifting economic growth, but also per capita income, and the country has a lot of room to grow even further.

So, how is it "of no significance at all"?
It's of no significance because the fundamental challenges facing China today are the same as they were last week or two weeks ago. The financial crisis had a double-edged meaning for China. It gave them the confidence that they had come out of it earlier and stronger. But for China's economic managers, the crisis highlighted the fact that the Chinese economy has relied on sources of revenue, like exports, that won't be there as before.

Moving forward, China's economy will depend more on local demand and less on the export economy. Some in the Chinese strategic class have said this is terrific because the country will have more influence, but some economic managers are asking where the growth is going to come from.

So it's not all good news for China, then?
China's biggest economic challenge is to rebalance the economy from exports to domestic consumption. And they still have to deal with resources issues, labor issues and manufacturing policy. Becoming the second-largest economy in the world is hugely significant because it confirms China's rise, but doesn't erase the underlying social and structural challenges underlying the economy. Chinese policymakers do not take for granted that they can rely on global export growth to sustain their economy in the long term.

Speaking of which, what are China's long-term prospects?
First of all, China's economy is slowing. First-quarter growth was a blistering 11.9%, but second-quarter growth was 10.4%. This is a managed slowdown, of course -- they were worrying about overheating.

But the long-term question is: Can they sustain 7% to 8% growth? Second, what kind of growth is China going to experience because they can no longer just rely on global growth to drive their economy anymore? How do they shift toward less reliance on global demand and more reliance on domestic consumption, whether through infrastructure investment or green energy or industrial policies that are designed to support domestic consumption?

How has China's relationship with its Asian neighbors and the U.S. changed?
China has become the most important Asian economic center in a way that was not the case even five years ago. It's the major trading partner of almost everyone in the region. It's also at the center of efforts to set technical standards. The U.S. is no longer the agenda-setter in the region. As the U.S. has become less active and relevant in global trade agreements, China is at the center of regional trade, financial activity and trade and technical standards integration. A possible trilateral trade agreement between China, Japan and South Korea could be very important.

Finally, U.S. and Chinese trade and economic tension is heating up on several fronts. The first is the currency issue, the second is industrial policy, and Democrats in Congress are focused on U.S. domestic manufacturing polices that could result in a bill that would affect trade with China. I expect that U.S. and Chinese economic tensions will increase in the next year.
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