As Japan Slips, China Moves Into Second Place

Economists have been saying for a while that China was on the verge of overtaking Japan as the world's second largest economy. That change in status has now become "official" as Japan's GDP dropped .3% in the fourth quarter of 2010, while China's climbed 9.8%. China's GDP for last year was $5.88 trillion, just ahead of Japan's at $5.47 trillion.

China's huge manufacturing system has become so powerful that Japan's faltering economy didn't have much of a chance. Japan was the low-cost provider of products used in Europe and the U.S. during the 1970s, but the cost of labor rose in the island nation. An asset bubble -- created in part by rapid GDP growth -- collapsed two decades ago, causing a period of "stagflation" that lasted over 10 years. Japan barely recovered as production of consumer electronics moved to nations like South Korea.

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Japan does not have the growth rate to challenge China to reclaim its No. 2 spot. The race is now between China and the U.S. Economists believe that at current GDP growth rates, China may overtake America in the next three of four decades.

But China's economic growth could falter -- and soon. Costs to operate its factories have risen quickly as wages for China's middle class have started to climb -- dramatically in some regions. The soaring costs of oil and other commodities will also squeeze margins and increase export costs. The advantage China has with its cheap exports could fade.

Capital markets experts also see a challenge to rising protectionism. The weak value of the yuan has increased political pressure from places like the U.S. and Brazil, each of which believes that China manipulates its currency. A trade war of even modest magnitude could undermine China's growth.

The other big challenge to the Chinese economy is harder to gauge. The government has begun to crack down on news from Egypt, limiting coverage to brief items, according to several reports. A challenge to China's political order and economic stability could come from within if there is a sharp rise in the movement to replace the current government with something more democratic.