Japan lost its 42-year ranking as the world's second-biggest economy to China in 2010, with data out Monday showing a contraction in the last quarter due to weak consumer spending and a strong yen.
While Japan was expected to fall behind a surging China in the year, the data underlined the weak state of a Japanese economy burdened by deflation, soft domestic demand and pressured by the industrialised world's biggest debt.
"It is difficult for the deflation-plagued Japanese economy to achieve self-sustained growth," said Naoki Murakami, chief economist at Monex Securities.
While China's leap forward reflects a shift in economic power as the country transforms itself from poverty-hit communist state to global heavyweight, it highlights the need for shrinking Japan to energise its economy, analysts said.
Japan's post-war "economic miracle" put it at number two behind the United States for more than four decades, but stagnation after the Japanese property bubble burst in the 1990s helped put booming China on course to supplant its neighbour.
However, Japan remains around 10 times richer on a per-capita basis, according to the International Monetary Fund.
Predictions vary as to when China may overtake the United States as number one economy, but it should happen by 2025, according to estimates by the World Bank, Goldman Sachs and others.
Japan's real gross domestic product slipped by an annualised 1.1 percent in the October-December quarter as the expiration of auto subsidies hit car sales, a new tobacco tax sapped cigarette demand and a strong yen hurt exports.
While the first contraction in five quarters was not as severe as forecasts of a 2.4 percent slide, Japanese GDP data is subject to constant revision.
The economy grew 3.9 percent in 2010, its first annual growth in three years. But this was not enough to keep it ahead of surging China.
Nominal GDP of ê5.474 trillion in 2010 put Japan behind China's ê5.879 trillion, the data showed.
Despite Japan crawling out of a severe year-long recession in 2009, its recovery remains fragile with deflation, high public debt, weak domestic demand and a strong yen all concerns for policymakers.
Pressure is on Prime Minister Naoto Kan, who has seen his approval ratings tumble as his government looks to boost the economy without deepening the debt amid a legislative impasse over his ê1.1 trillion budget for the next fiscal year.
Last month Standard & Poor's cut Japan's credit rating one notch to "AA-" from "AA", saying the government lacked a "coherent strategy" to ease a debt running near 200 percent of GDP, the highest of any developed nation.
Nearly a third of government spending is being swallowed up by a social security system catering to a rapidly greying society, Standard & Poor's warned, with that ratio set to rise without reforms as Japan continues to age.
Kan's centre-left government has prioritised social security reform and a tax system overhaul, but the opposition has so far refused to begin talks on the issue.
Private consumption, accounting for about 60 percent of Japan's GDP, slid by 0.7 percent quarter-on-quarter in October-December as subsidies for green car purchases expired and as cigarette sales were dented by Japan's biggest ever tobacco tax hike.
Exports slipped in the quarter as the yen surged to 15-year highs against the dollar, making Japanese goods more expensive overseas and eroding repatriated profits.
But many analysts expect the economy to rebound in the January-March quarter as the rising tide of global recovery lifts Japan, amid a recent pick-up in corporate spending and exports.
"The contraction will not last long," said Murakami. "Companies' manufacturing activities are recovering rapidly in January-March this year from their bottom in October 2010."
The government said Japan's economy would be helped by recovery elsewhere and could reap the benefits of its huge neighbour China, the world's number-one export market.
"We welcome, as a neighbouring nation, that China's economy is advancing rapidly," said Kaoru Yosano, minister for fiscal policy.
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