Is China really the second most powerful economy in the world?

In GDP terms, China may be the world's second-largest economy. But a new report by S&P shows exactly why Japan is still an economic powerhouse.

When the Chinese economy finally overtook Japan in 2010, it was greeted with a sense of jubilation in China. For many Chinese, it was a historic moment when the Middle Kingdom resumed its rightful place in East Asia.

The victory was even sweeter considering Japan was a bitter former foe that had invaded and defeated China since the time of the Meiji Restoration in the 19th century. By the end of 2013, China’s GDP was 2.8 times larger than Japan’s, as measured by purchasing power parity, which better reflects relative prices in two economies for the same goods.

Not only has China overtaken Japan, the country is also poised to overtake the US by the end of this decade. China is often seen as the bright star of the future, despite its recent slowdown. Meanwhile Japan is often regarded as shorthand for stagnation and economic mismanagement.

Does GDP alone provide an accurate or a complete picture of the economic strengths of the world’s second- and third-largest economies? According to Standard and Poor’s, the answer is no. The ratings agency has issued an interesting report that challenges conventional wisdom by comparing the two countries according to a different set of metrics.

This may be pointing out the obvious; your average Mr Tanaka is still much richer than your average Mr Wang. As of 2013, China’s per capita GDP was US$9,828, a quarter of Japan’s US$37,135. Today’s Chinese living standard is comparable to Japan’s in the early 1980s.

Though Japan has stretched its "lost decade" into two, it still enjoys one of the highest living standards in the world. When a British MP visited a supposedly economic-stagnant Japan, he said, “If this is a recession, I want one,” according to Financial Times Asia editor David Pilling in his book Bending Adversity: Japan and the art of survival.

China and Japan are both export juggernauts. In 2012, China exported US$2.9 trillion worth of goods, while Japan sold US$1.2 trillion worth of goods abroad. Over the past 28 years, China has grown considerably faster than Japan, at an annualised compound rate of 16.6 per cent versus Japan’s 6.6 per cent.

However, if you look at the composition of the two countries’ exports, it tells a different story. Around 70 to 80 per cent of Japanese exports are medium and high-tech exports, while for China, they account for about 60 per cent. It’s clear that from a low level in the 1980s, China is catching up quickly with Japan. But the gap has stabilised at around 15 per cent in the last five years, according to Standard and Poor’s report, Is China’s Economy Really Besting Japan’s? A look beyond GDP.

Though there is a lot of talk of China buying up the world, let’s not forget the Japanese started this process as far back as the 1980s. Hollywood even made a blockbuster movie, Rising Sun, about Japan Inc’s conquest of the US.

Japan’s international investment positions or financial claims on the rest of the world stood at US$8.3 trillion in 2012, or 175 per cent of its nominal GDP. By comparison, China’s claim was about US$5.2 trillion, according to IMF data.

Though the gap is considerable, it is closing fast as China invests more aboard. However, Beijing has splurged nearly two thirds of its overseas investment into US Treasury bonds, which provide a safe but sub-optimal return. Despite all the hype about direct Chinese foreign investment, it only accounts for 10 per cent of the US$5.2 trillion.

On the other hand, nearly half of Japan’s total overseas investments are in bonds and equity claims and only 16.5 per cent are invested in official foreign reserves. It’s clear that Japan is the more mature international investor, with a better and more diversified investment portfolio than the Chinese, who still put their money in ultra-safe government bonds.

Though China has some of the largest banks in the world, its financial market is still relatively under-developed. According to the World Economic Forum’s Financial Development Index in 2012, Japan ranks 9th, while China is at a distant 23rd place.

Japan’s financial sector is larger than China’s for most metrics, including bank assets, bank and financial system deposits and private credit, according to Standard & Poor’s. Japan’s public bond market is the largest in the world, at 208 per cent of GDP in 2011.

In terms of innovation, although once-formidable Japanese corporates such as Sony, Toshiba and Panasonic are shadows of their former selves, the country is still one of the most innovative in the world, according to Bloomberg’s Global Innovation Index. It ranks 9th, while China sits in 29th position.

But Chinese companies are catching up fast, and it was in the top 10 for patent activity, as well as for manufacturing capability and high tech-density in 2012. Chinese e-commerce is arguably leading the world in terms of its development, and Japan’s Softbank is the largest investor in Alibaba.

Despite the trillions that Beijing has invested in bridges, railway, airports, the country’s infrastructure is still lagging behind Japan’s. According to the World Economic Forum, Japan ranks 9th globally for infrastructure, while China is in 48th place.

This is a timely reminder for people who believe in the inevitability of the rise of China as an economic superpower. The pretender to the US throne looks less imposing when you examine the quality of its GDP rather than just its raw number. Japan is still a formidable economic powerhouse, despite its recent stagnation, while China’s ascendency should be looked upon with more scepticism.

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