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Tokyo - Eclipsed by China after posting its weakest growth in three quarters, Japan must now safeguard its fragile recovery and work to benefit from the rise of its huge economic neighbour, say analysts.
As cooling exports and flat domestic consumption dragged on Japan's growth in April-June, Monday's data pointed to the looming prospect of China overtaking Japan as the world's second-largest economy this year.
Pressure is now on Japan to remedy the economic woes that threaten to derail its recovery, while working to reap the benefits of the rise of China, the world's number-one export market.
"China has replaced Japan as the centre of Asia," said Takahide Kiuchi, senior economist at Nomura Securities. "Japan now needs to take advantage of growth in China and the rest of Asia."
Japan's real gross domestic product growth fell to an annualised 0.4% in the quarter, down from a revised 4.4% in the previous three months, while missing forecasts of 2.3% growth.
In nominal terms Japan's second quarter GDP was smaller than China's, at $1.288 trillion compared with $1.336 trillion, the government said.
Japan's post-war "economic miracle" put it at number two behind the US for more than 40 years, but stagnation after its property bubble burst in the 1990s has helped put China on course to supplant it this year.
China has already claimed the titles of world's biggest exporter, auto market and steelmaker.
"It's no surprise given the huge difference in population of both economies," said Yoko Takeda, senior economist at Mitsubishi Research Institute.
Japan remains more than ten times richer on a per-capita basis, according to the International Monetary Fund.
Loosen monetary policies
"But China's economic growth is a plus, rather than a minus, for Japan's economy because China will grow as a market for Japanese exporters," Takeda added. Japan's exports to China rose 22% on-year in June.
While China's soaring growth reflects a shift in economic power as the country continues its transformation from poverty-hit communist state to global heavyweight, it also highlights the need for Japan to re-energise its economy.
"Japan's economy is slowing as the rapid rebound from the global financial crisis cannot continue forever," said Kiuchi, noting that the expiry of stimulus packages and a stronger yen have exacerbated the country's weakness.
Despite crawling out of a severe year-long recession in 2009, Japan's fragile recovery remains beset by deflation, high public debt, weak domestic demand, softening exports and a strong yen.
All of which pose a challenge for Prime Minister Naoto Kan's government and its agenda focused on cutting the industrialised world's biggest public debt, at nearly 200% of GDP.
Committed to cutting spending and recently proposing doubling sales tax to 10%, the government has signalled it will consider further stimulus.
But for Japan to re-boot growth, it needs to be less reliant on exports, boost domestic demand and attract more foreign investment, analysts say.
"Japan can also explore the potential of the Chinese market for its service sector, including retail and insurance sectors," said Kiuchi.
Shipments of cars, gadgets and components have been crucial in off-setting weaker demand at home, but there is concern Japan may be hit by Beijing's efforts to cool China's economy and fragile eurozone and US demand.
A strong yen, which recently touched a 15-year high against the dollar, is hammering overseas profits of makers such as Sony, Nintendo and Toyota.
"The government can mitigate the impact of the stronger yen by nudging the Bank of Japan to loosen monetary policies," said Kiuchi. "Monetary easing is the only way to help Japanese exporters."
The central bank has long kept its key rate at a rock-bottom 0.1%, but analysts say its options are limited given that the yen's strength is derived from fears for the global economy and dollar weakness.
But amid hopes the government will conjure a bolder monetary policy to soothe the economy, Japan is resigned to its redefined place in the world behind China.
"I'm not happy about the news but I think it was inevitable," said Emiko Harada, 38, a shopkeeper in Tokyo's upscale Ginza district.
"It was surprising in the first place that a small country like Japan was second in the world. We did well."
