News that China surpassed Japan as the world’s second largest economy is one of the biggest stories in the financial markets. For more than four decades, the only country with a larger economic output than Japan was the U.S. However, over the past 20 years, the Japanese economy stagnated, giving China the opportunity to usurp Japan and snag a title that it has held since 1968. Just five years ago, China’s gross domestic product was around $2.3 trillion, about half Japan’s but rapid growth has pushed economic output to $5.88 trillion in 2010. While the Chinese economy grew, the Japanese economy contracted by 1.1 percent, bringing Japan’s economy to $5.47 trillion last year.

Although the absolute size of their economies are comparable in U.S. dollar terms, Japan and China could not be any more different. China has 10 times more people than Japan, but the GDP per capita is also 10 times less. Some may look at this as room for growth, but the rest of us may feel that the income inequality reflects the inherent weakness of the China economy. More than 150 million people, which is 10 percent of the population live on less than $1.25 a day. While growth in Japan is likely to pick up in 2011, it will have a very difficult time reclaiming its title from China.



Will China Usurp the U.S.?

The next big question investors are asking is whether China will usurp the U.S. to become the world’s largest economy. Currently the U.S. economy is 3 times the size of China’s which means that the Chinese economy would need to triple in order to match U.S. levels. This is an incredible feat that will be difficult to achieve but not inconceivable. In fact, many economists believe that China could eclipse the U.S. sometime between 2020 and 2030. Chinese incomes are rising and it is the government’s goal to reduce income inequality significantly over the next decade.

Implications on the Chinese Yuan

For the financial markets, this means that over the next 20 years, there will be a significant change in the dynamics of the foreign exchange market. Not only will the Chinese Yuan be revalued and set at higher and higher levels, but I expect much more flexibility in the Chinese currency. In fact, by 2030, I would be surprised if the Chinese Yuan did not become a free floating, fully convertible currency that is as actively used as the euro and possibly even the U.S. dollar. This will of course undermine the importance of the Japanese Yen and other currencies.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.