Historic Shift As China Overtakes Japan, Becoming World's Second Biggest Economy

Culminating a remarkable rise, China has surpassed Japan to become the world's second biggest economy, after the US.

Japan's economy slowed more than expected in the second quarter, pushing it into third place. While China's economy surged ahead at a 9% clip, Japan's economy sputtered along at a meager 0.4% rate. Yet, that was robust compared to the first quarter, when Japan's GDP increased by just 0.1%.

With an aging population and low birth rates, Japan has fewer workers relative to its retirees. As a result, Japan may have fallen behind China for good.

China's ascendency and Japan's decline are rather stunning developments, revealing that the two Asian nations are going in very different directions. Five years ago, China's GDP was equal to around half of Japan's.

The magnitude of this reversal cannot be overstated. Simply put, it is absolutely historic. Japan had held the number two spot, behind the US, since 1968, when it overtook West Germany.

For the time being, America's GDP remains nearly three times as large as China's. Yet, some economists predict that China could pass the US in total output in just 10 years. However, due to its enormous population, China's income per capita remains a fraction of the United States'.

The Asian giant is still a developing nation; its per capita gross national income was ranked 127th in the world at the end of 2008, at $2,940, according to the World Bank.

China's stunningly rapid growth was built on manufacturing and exporting; it became the global leader after surpassing Germany last year.

But with the global economy slowing, the demand for Chinese goods will likely slow, as it has for Japanese goods. In order to continue its meteoric ascent, China will have to boost domestic demand, a challenge in a historically frugal nation that is more inclined to save.

That will pose a challenge, yet China is already the world's leading auto buyer. As incomes continue to rise in China, its citizens may ramp up domestic purchases. That would make it less reliant on exports.

As it stands, China's economy has been growing at about a 10% clip in recent years. While that is expected to slow to a 6 - 8% rate in future years, it is well above what most economists anticipate the slowing Japan and US to manage.

Due to its vast exports to the US, China has built up massive foreign currency reserves. In fact, China is the biggest holder of foreign currency assets in the world -- most of them in U.S. dollars.

However, there are signs that the dollar may be falling out of favor with the Chinese, supplanted by the euro.

Beijing has sold more than $70 billion worth of its U.S. government debt over the past year.

Meanwhile, a former official at the Chinese central bank is quoted saying: "We have been buying quite a lot of European bonds."

With the US debt exceeding $13 trillion, and budget deficits as far as the eye can see, China may be losing faith in the dollar.

Though China doesn't seem to be in any rush to dump its US holdings, it is clearly moving to diversify by shifting into European, and perhaps other, bond markets.

What we are seeing is a sea-change on the global economic landscape. If there was ever any doubt, it is now clear that China is a major and dominant player on the world stage.