On purchasing power parity, China surpassed Japan ten years ago. However, on per capita income parameter, China is still a poor country.

China has overtaken Japan. In terms of US dollars the Chinese economy is expected to be the world's second largest economy by the end of the year surpassing Japan. Over the past decade, the Chinese economy has boomed while the Japanese economy has stagnated. This is especially true this year when China often experienced double-digit growth. In contrast Japan's most recent growth rate was an anaemic 0.4%. At this rate, China is expected to surpass the US economy by 2026 or even earlier. Of course, all economic forecasts have one thing in common. At some point in the future, they will be wrong.
 
For a start it is old news. China's GDP will most likely outstrip Japan's GDP this year is based solely on the total numbers expressed in dollar terms. If looked at in terms of the more accurate measure, Purchasing Power Parity (PPP), China surpassed Japan ten years ago. From another perspective, China has not passed Japan at all. It is still a poor country. Its per capita income is barely one tenth that of Japan. So the reality of the present level of China's economy varies depending on how you twist the numbers.
 
The real fanfare about the story comparing China to Japan was the projection that the Chinese economy would be the largest in the world within a relatively short period of time. Unlike the present numbers, which have some basis in reality, the projections simply do not. Let us look at some prior numbers.
 
In 1981, the per capita income of Saudi Arabia was 60% greater than the US. There seemed to be no reason at the time to believe that the statistic would change. Instead, today the situation is reversed. Even using PPP, the per capita income of Saudi Arabia is half that of the US. In the 1950s Latin America had incomes that were 25% of US levels. It was forecast that in a few decades they would catch up. At the time, the average income of Asia was only one tenth of America's. The forecast was that it would not change. What actually happened was the reverse. Asia's average income is 25% of the US while Latin America's relative wealth has actually declined. Their incomes are now only 20% of the US averages.
 
The probability is that the same thing could happen to China. Recently there have been stories that the US is going the way of Japan. Commentators have predicted that the US will like Japan have a lost decade of deflation and limited growth. The real comparison is between Japan and China and it is not about their relative GDPs.
 
The real comparison between China and Japan is their development model. This model has been used by various countries in various ways, but the theme is similar. Basically the government uses different policies to shift wealth away from households to investments in manufacturing and infrastructure. The process can be accomplished directly by taxing households and using the proceeds to provide subsidies for manufacturing and infrastructure as was done in Brazil during the 60's and 70's. Or it can be done indirectly as in Asia by restraining wages, undervaluing the currency, and keeping the cost of capital extremely low.
 
Often the Asian model has been mistaken as having something to do with culture rather than government policy. It is an article of faith among many economists that Asian cultures are somehow thriftier and better savers because of some sort of Confucian ethic. Of course this is just silly. Asians are just as happy as Americans to spend, if their governments let them do it, while the compulsive shoppers in America are now saving over 6% of income.
 
What government policy does do is distort the incentives and disincentives within the economy. Development models that shift wealth from consumption to investment by whatever means may, in the short run, produce exceptionally rapid growth, but there is a price to pay. When governments make the decisions instead of the market, the result is a misallocation of capital and in the case of Japan and now China massive overinvestment.
 
As the Chinese academician, Yu Yongding, recently pointed out, "A viable economy cannot be built on steel and concrete alone," and "China's problem is more its poor allocation of resources." But knowing what the problem is does not mean that it can be solved. Entrenched government policies in any country cannot be easily changed. Policies that distort markets build their own following. Political forces within the society who have profited from any given policy have enormous economic incentives to see those policies continue. In China the combination of local governments, developers, exporters, state owned industries and banks all have financial stakes in continuing the present policies at the expense of China's consumers, trading partners and ultimately the growth the economy.
 
So the reason why China has been able to overtake Japan economically is paradoxically the same reason why Japan's growth has faltered and why China's economy will soon follow suit.   

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).— William Gamble