In today’s Asia, there are two economic powers of global standing, Japan and China. But the balance of economic power between the two is changing, and fast. Sometime this year, China’s GDP will exceed that of Japan (if it has not already done so). China’s economic footprint, moreover, is spreading rapidly across Asia and the rest of the world.

Most Asian countries are recovering strongly from the global recession that set in following the collapse of Lehman Brothers in 2008. China’s growth rate last year was 8.7%, and more than 10% in the past two quarters.

Neighboring countries, like South Korea and Singapore, also are recording very high rates of growth. The only exception is Japan, where a lack of political leadership and a limited knowledge of basic economics among government ministers undermines mid-term growth prospects.

While China’s ability to maintain high growth through the "Lehman Shock” was a remarkable feat of economic management, three important changes in China hold geo-political implications for the region and the world.

The first change concerns China’s pattern of economic growth, which so far has been achieved mostly by rapidly increasing factor inputs – labor, capital, and energy.

According to recent research, however, about one-third of growth in China now comes from technological progress, or an increase in total factor productivity. In other words, China’s growth pattern is coming to resemble that of industrialized economies.

Second, the renminbi is expected to appreciate substantially in the coming years, owing not only to pressure over China’s huge trade surplus, but also to the Chinese government’s understanding that a stronger renminbi, despite its negative impact on exporters, is needed to fight inflation.

The question is how rapidly will China’s authorities allow the renminbi to appreciate. In 1989, before the Tiananmen Square incident, the renminbi’s exchange rate was 45% higher than it is now – a level that could be re-attained relatively soon. Between 2003 and 2005, the renminbi appreciated by 20%.

Given rapid economic growth and continuous renminbi appreciation, Chinese GDP could exceed that of the US as soon as 2015.

But around 2015, China will face a third dramatic change – a demographic shift reflecting the effects of its long-standing one-child policy. China’s total fertility rate is estimated at around 1.5, implying that the working-age population will begin to decline by the mid-2010’s.

As a result, economic growth will slow, and China’s domestic problems – such as income inequality – will worsen, even as political institutions that can channel popular grievances remain underdeveloped.

Under such circumstances, the role of political leadership will become much more important. President Hu Jintao will step down in 2013, but will continue to hold his post on the all-important Central Military Commission until a complete succession is completed, also around 2015.

So, all things considered, China’s looming leadership transition is shaping up to be a very challenging period for China and the world.

While China’s economy is growing very rapidly, Japan is still struggling. Indeed, the country desperately requires strong political leadership to prevent a Greek scenario – political leadership that it is unlikely to find. On the contrary, the recent resignation from the premiership of Yukio Hatoyama created more uncertainty than his own government did.

Hatoyama’s cabinet, led by his Democratic Party of Japan (DPJ), ignored macroeconomic management after taking office in September 2009. Instead, as the DPJ had promised its voters, the government focused on increasing spending, including huge new grants to households and farmers.

As a result, the share of tax revenue in total spending is less than 50% for the first time in Japan’s post-war history. And the government debt-to-GDP ratio is around 190%, compared to 120% in Greece.

Nevertheless, the market for Japanese Government Bonds (JGBs) has so far remained stable. Because JGBs are purchased mainly by domestic organizations and households, there is little risk of capital flight, despite the seriousness of the budget situation. In other words, the government’s negative saving is being financed by the private and household sectors’ positive saving.

This situation, however, is changing. First, the volume of JGBs has soared relative to Japanese household assets.

Japanese households hold about ¥1,100 trillion in net monetary assets, an amount that will be exceeded in about 3-5 years by the value of JGBs. At that point, government debt will no longer be backed up by taxpayers’ assets. And, reflecting the aging of Japanese society, the household savings rate itself will decline dramatically, making it difficult for the private sector to finance annual budget deficits.

At the same time, Japan’s demographic trends will boost demand for fiscal expenditure, as pension and health-care costs rise. So, sooner or later, a tax hike will be necessary.
Without comprehensive reform under strong political leadership, a tax hike alone cannot solve Japan’s problems. And the impact on Asia and the global economy of a fiscal crisis in Japan would make Greece’s troubles look like a walk in the park.

Greece’s GDP share in the European Union is about 3%. Japan’s GDP share is about one-third of Asia and 8% of the world.

So the future in Asia now appears to belong to China, whose economic growth supports that of neighboring countries – and whose mercantilism is prevailing in the region. In order to compete with China’s export-boosting public-private schemes, other Asian countries are now pursuing similar policies.

In some cases, this will harm free trade, and governments should be careful to avoid measures that distort resource allocation. This matters for every country, because Asia is now an important center of global economic growth.

The world’s expectations for responsible economic management by the governments of both China and Japan – and thus the need for it – are growing by the day.

Heizo Takenaka was Minister of Economics, Minister of Financial Reform, and Minister of Internal Affairs and Communications under Prime Minister Junichiro Koizumi; he is currently Director of the Global Security Research Institute at Keio University, Tokyo.

Copyright: Project Syndicate, 2010.