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The Associated Press August 1, 2010, 12:00AM ET

China setting milestone as economy passes Japan's

China is set to overtake Japan as the world's second-largest economy in a resurgence that is changing everything from the global balance of military and financial power to how cars are designed.

By some measures it has already moved to second place after the U.S. in total economic output -- a milestone that would underline a pre-eminence not seen since the 18th century, when the Middle Kingdom last served as Asia's military, technological and cultural power.

China is already the biggest exporter, auto buyer and steel producer, and its worldwide influence is growing. The fortunes of companies from Detroit automakers to Brazilian iron miners depend on spending by China's consumers and corporations. And rising wealth brings political presence: Chinese pressure helped to win developing countries a bigger voice in the World Bank and International Monetary Fund.

"Japan was the powerhouse driving the rest of Asia," said Rob Subbaraman, chief Asia economist for Nomura Securities. "Now the tide is turning and China is becoming a powerful influence on the rest of Asia, including Japan."

China's rise has produced glaring contradictions. The wealth gap between an elite who profited most from three decades of reform and its poor majority is so extreme that China has dozens of billionaires while average income for the rest of its 1.3 billion people is among the world's lowest. Beijing has launched two manned space missions and is talking about exporting high-speed trains to California and Europe while families in remote areas live in cave houses cut into hillsides.

Japan's people still are among the world's richest, with a per capita income of $37,800 last year, compared with China's $3,600. So are Americans at $42,240, their economy still by far the biggest. But Japan is trapped in a two-decade-old economic slump, the U.S. is wrestling with a financial crisis, and China's sheer economic size and the lure of its vast consumer market adds to its clout abroad.

Its explosive growth has driven conflicting shifts in Asia and beyond, triggering a scramble for commercial opportunity but fueling unease that the wealth is helping to finance a military buildup to press the communist government's claims in the region.

"I think everyone in the region is trying to benefit from Chinese economic dynamism but at the same time is trying to make sure China does not become a regional hegemon," said Greg Sheridan, foreign editor of The Australian newspaper.

Exactly when China passes Japan formally will be unclear until after this year ends. It depends on shifting exchange rates and data reported in different forms by the two governments.

Chinese GDP in 2009 was $4.98 trillion and Japan's was $5.07 trillion. In 2010, Chinese GDP was $1.335 trillion for the April-June quarter -- a period for which Tokyo has yet to report. China is growing at 10 percent a year, while Japan's expansion this year is forecast at no more than 3 percent.

"On that basis, the crossover probably happened last quarter," said Julian Jessop, chief international economist for Capital Economics in London, in an e-mail.

Beijing appears to take it for granted that it already has overtaken Japan.

"China already is the world's second-biggest economic body," said a deputy central bank governor, Yi Gang, in a policy discussion posted July 30 on the foreign exchange agency's website.

Australia has been one of the biggest beneficiaries as China's voracious appetite for iron ore, coal and other commodities drove a mining boom that kept its economy growing through the global crisis.

That booming trade prompted Australia to reconsider its stance toward China, previously seen as a communist aggressor. In 2008, then-Prime Minister Kevin Rudd, a Mandarin-speaker who was a diplomat in Beijing, called for closer political, economic and academic engagement with the Chinese government.

But Rudd also displayed Australia's independence from Beijing by talking about human rights, Tibet and China's Muslim minorities -- issues Chinese leaders want other countries to keep quiet about. And Australia affirmed its longtime security alliance with Washington -- a counterweight to China's growing might. Rudd's successor, Julia Gillard, has given no sign of a major change of direction.

In the long historical view, China's 21st century rise is a return to the status it held for most of the past 2,000 years as "Zhong Hua," or the Central Brightness, East Asia's economic and military giant and a beacon of technology and elite culture to societies from Vietnam to Korea to Japan.

China's was the biggest economy, with its workshops and textile mills accounting for up to one-third of global manufacturing. But it went into steep decline in the 19th century as its rulers resisted mimicking Japan's embrace of Western technology. By the 1930s, China produced just a few percent of global factory output.

After a civil war, communist takeover and political upheaval, free-enterprise reforms pioneered by leader Deng Xiaoping opened the door for hundreds of millions of Chinese to work their way out of poverty.

Since those reforms began in 1979, China has grown into the world's low-cost factory, its biggest exporter and producer of half its steel. It wants to evolve beyond cheap manufacturing and is trying to build up technology industries but has had little success so far.

Last year, the World Bank ranked China 124th among economies in per capita income, behind Latin America and some African nations, while Japan was No. 32. The United States was 17th.

Yet already, China's consumers are so avidly courted by global companies that products from autos to home appliances destined for sale worldwide are designed with their tastes in mind. This year, French luxury goods maker Hermes Group unveiled a brand, Shang Xia, to be designed specifically for Chinese customers.

Unlike Japan, which renounced aggressive force after its World War II defeat, Beijing sees itself as Asia's rightful military leader. It has openly possessed nuclear weapons since the 1960s and is spending heavily to build up the Communist Party's military arm, the 2.5 million-soldier People's Liberation Army.

Beijing's military outlays are the world's second-highest and have tripled since 2000 to an estimated $100 billion last year, though well behind Washington's $617 billion, according to the Stockholm International Peace Research Institute.

China's demand for oil, iron ore and other raw materials is pumping money into developing economies as far-flung as Angola and Kazakhstan that supply them. Chinese companies are making inroads into Africa in search of resources and markets.

"Now, Africa has an alternative development model," said Derek Scissors, a Heritage Foundation scholar in Washington. Instead of Western investment with environmental or other strings attached, Scissors said, "they now see the Chinese as an alternative: `We don't want to deal with you. We'll get some Chinese state-owned company to put $1.5 billion into this mining project.' "

Chinese pressure helped to trigger the biggest changes in decades in the U.S.- and European-dominated World Bank and IMF, which agreed to give China, Turkey, Mexico and other developing countries a bigger say in picking leaders and deciding policy.

The boom has helped communist leaders pay to cultivate "soft power" -- educational and media activity to win hearts and minds abroad.

Of course, even after slipping to third place, Japan is still rich and comfortable -- the Switzerland of Asia.

The society that created hybrid cars and the Walkman has 99 percent literacy and the world's longest life expectancy at 83 years. Tokyo is the capital of fine dining, with more Michelin-starred restaurants than Paris.

Toyota has overtaken General Motors as the biggest global automaker at a time when China companies have yet to establish their own brand names.

Now, with Japan in the rear view mirror, can China catch up with the United States?

Yes, say many analysts.

China could match the U.S. in total output as early as 2020, said a World Bank forecast in June. But still, it said per capita income would be one-fourth the U.S. level, comparable to Malaysia or Latin America.

Achieving even that will require China's unelected, secretive leaders to radically change their state-dominated economy.

They need to promote technology and education, fight rampant corruption that is stoking public anger and resist temptation to favor government-owned companies at the expense of a dynamic private sector that creates jobs and wealth.

Success is far from guaranteed, warn the World Bank and others.

They say China, Mexico and other developing countries easily can stall at middle-income levels if they fail to develop an educated, creative work force and legal systems to support innovation or if they allow entrenched companies to stifle competition.

"Are they going to pass the U.S. in total GDP? Yes, very likely," said Scissors. "Are they going to move into upper-middle-income status? That's a much tougher thing."

------

AP Business Writer Tomoko Hosaka in Tokyo contributed to this report.


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