Japan overtakes China as the world's third largest economy

By R.A. | WASHINGTON

IN MANY ways, the big story today was not China's leap ahead of Japan in terms of nominal output, but Japan's dramatic second quarter slowdown. These days, the growth race is more about who is slowing slowest rather than who is growing fastest. And Japan's economy is slowing faster than China's. Japanese output rose at just a 0.4% annual pace in the second quarter, down sharply from the economies 4.4% first quarter performance. It was worse, too, than the 2.3% rate economists had expected. Consumption was flat, and exports were battered by a rising yen (which, rather obnoxiously, rose on the latest GDP news). The Wall Street Journal had this to say about the halt in consumption growth:

Deflation also continued to drag on economic growth. Persistent price falls encourage consumers to defer purchases as they wait for prices to fall even further. They also hurt business investment by weighing on firms' bottom lines and increasing real borrowing costs.

The GDP deflator, the broadest measure of price trends, was minus 1.8% during the April-June quarter. The result represents a mild improvement from the minus 2.8% in the previous quarter, as price falls have eased slightly. But it still underscores how deeply entrenched deflation is in Japan.

"The risks of protracted deflation are increasing rather than improving," in contrast with the Bank of Japan's outlook, said Junko Nishioka, chief economist at RBS Securities Japan. That could prompt the government to put more pressure on the Bank of Japan to take additional easing measures, analysts said. The central bank's policy board, which held a regular two-day meeting last week, decided against taking such steps for now.

This is the place we'd prefer the global economy avoid—a global lull in recovery, widespread fears of deflation, exchange rate feuds and trade disputes. As I noted last week, China has been buying yen, contributing to the currency's rise and risking trade tensions with Japan. At the same time, the yuan has fallen sharpy against the dollar in recent days, giving back half of the appreciation sustained in June and July. The picture is of a Chinese economy struggling to maintain export strength as the economy slows, perhaps more rapidly than Chinese officials prefer.

European leaders are no doubt anxious to see more yuan appreciation, as well, but with some added concerns. Europe's recovery is overwhelmingly driven by an unparalleled boom in Germany. And Germany's recovery is based, in no small part, on strong growth in exports to China. Chinese appreciation against the euro would improve the cost competitiveness of German exporters. But it might also generate a dramatic slowdown in the Chinese economy, entirely offsetting the benefit from the exchange rate move and depriving Europe's economic engine of its fastest growing export market.

The Financial Timescomments:

But what worries many industrialists is how lopsided the growth is towards Asia and other emerging economies such as Brazil, bringing a large part of corporate Germany into a dangerous dependence on the Chinese market in particular. “Without China we would hardly have seen this recovery – it's a frightening trend,” says Hannes Hesse, head of the VDMA engineering association, adding that demand for textile machines is “almost exclusively” Chinese...

[F]ew doubt that a slowdown in China would hit the German economy harder than others. A number of German industrialists are already warning that the second half of the year will be tougher. “There is no reason to become overly optimistic ... We see a waning recovery in the US and Asia will grow more slowly in the second half,” says Jürgen Hambrecht, chief executive of BASF, the largest chemical maker in the world.

China's gross domestic product growth slowed from 11.9 per cent to 10.3 per cent in the second quarter from the first, reflecting government efforts to restrict bank lending. A continued softening would threaten to derail Germany's export boom at a time when government austerity measures in Europe are upsetting growth prospects in its own backyard.

Meanwhile, the European Central Bank reported a 1.7% annual increase in consumer prices in July, up from 1.4% in June—news that may lead the ECB to step up planned tightening. That would be a mistake. The annual increase in core prices was just 1% in July, up from 0.9% in June. And the price level actually ticked downward from June to July, just not by as much as it fell from the prior June to the prior July.

The situation, broadly speaking, remains clear. Most large economies are beset by various structural issues, but the big threat of the moment seems to be central bank refusal to battle deflation and disinflation, leading to a hamstrung global economy and a likely increase in the nastiness of fights over shares of the world's inadequate global demand.