With Japan’s fourth quarter GDP showing an annualized decline of 1.1%, China confirms herself as the second largest economic nation in the world. Japan’s fight against deflation is still evident in the fourth quarter numbers. Global inflationary pressures, supported by commodity prices driven up by the structural strength of emerging markets, might actually ease this problem. But for now, Japan has lost its 42-year-old status as the world’s number two economy. The strong Yen and the end of consumer incentive have combined to put pressure, despite the fact that capital expenditure and residential property activities were stronger than most people expected.

With a median age of 44.7, Japan is 15 years above the average global age and by 2050 the elderly ratio will reach 75%. This means that for every four workers, three people will be retired. The demographic challenges of Japan are a well known fact and its

population is actually expected to decline by almost 30% by 2055. However, the size of the debt burden is sometimes overlooked. Because of the stimulus plan Japan put in place to help its economy during the financial crisis, its deficit will most likely reach 10% of GDP in 2010. This will bring the government debt-to-GDP ratio to about 200% and the total debt-to-GDP ratio to close to 500%.

While it is hard to see how Japan’s demographic weakness could be reversed, the key for economic success can be found in part in how productive its assets are and how successful it can harness its rapidly maturing and economically successful neighbour: China. While China’s GDP is expected to be double that of Japan by 2019, China’s inward push – its effort to further develop its domestic demand and lower its reliance on exports – could be beneficial to Japan. January data show Chinese imports up 51%, highlighting the importance of the country’s dynamic domestic growth on the region. China has overtaken the US as Japan’s largest trading partner and the key to compensating for the Japan’s weak domestic trend is in the country’s own hands. However, what might be needed in addition to pure economics is a continued improvement in soft factors and a cultural “rapprochement”.