We've seen this China story before-in Japan

In what year will China pass the United States to become the world's largest economy? To the economic cognoscenti, it really is a matter of when, not if. The Economist even has an online game: Enter your assumptions for growth, inflation and currency, and the website spits out an answer. The magazine's default settings have the Big Event occurring in 2018.

On the face of it, China's ascension to the top seems a sure bet. It became the world's No. 2 economy in 2010, after a long period of vigorous growth, powered by exports and massive building of highways, factories and other accoutrements of rapidly developing countries. This has raised the standard of living of millions of Chinese, caused property values to soar and created considerable financial muscle. Not only does China help finance America's hulking deficits, it has also built some global-scale financial institutions, such as Industrial and Commercial Bank of China. Its companies are now throwing around billions buying assets in foreign lands.

No, there's no stopping China—until you consider that every one of those things was also true of Japan a quarter-century ago. The China of today resembles the Japan of 1988 a lot more than China's many cheerleaders and apologists care to admit.

The 21st century was supposed to be "the Japanese century"; that the country would catch the United States by 2000 was all but guaranteed. "We are living through the greatest transfer of wealth and economic power that's ever happened in peacetime. What used to happen only on the battlefield, they are doing through the stock market," said Canadian economist Kenneth Courtis in 1990, when he was Deutsche Bank's economist on the ground in Japan. The Tokyo market has fallen by about 75% since then.

One can hardly blame Courtis. Everyone else believed it, too. At the time, it looked like Japan had a formula for a better capitalism. Japan Inc. was a tight network of export businesses, funded by cheap capital from large Japanese banks with close ties to the Ministry of Finance. But the formula relied heavily on borrowed money. As Japanese banks, businesses and households sank into debt in the mid-80s, stocks and property values swelled to absurd heights, and then the bubble burst.

"Every country that has followed this growth model has ended up with a debt crisis," says Michael Pettis, a finance professor at Peking University in Beijing who specializes in Chinese financial markets. A former Wall Street man, Pettis has spent much of his career working in emerging-market countries, so he's seen a financial crisis or two.

The growth model has several elements—a cheap currency is often one—but the most important is a heavy hand of government in directing banks and credit markets to fuel industrialization. It worked for a while in the Soviet Union in the 1950s, in Brazil in the '60s and '70s, and in Japan in the '80s. But each of those booms ended in crisis or economic stagnation.

China is next. "My guess is we couldn't do this for more than four or five years without running into serious debt constraints," Pettis tells me. Ignore official figures that show that government debt is low. "Anyone can run a budget surplus if you throw all of your expenses onto something else," he says.

In China's case, that something is the state-controlled banking system. When the global financial crisis hit in 2008, the government pushed the banks to keep lending freely and cheaply. That accelerated the large-scale blowing of cash on uneconomic projects and unnecessary infrastructure. By now, practically everyone has heard of the new office buildings and apartment blocks with no tenants, or the giant New South China Mall, which is larger than the West Edmonton Mall and almost completely empty. "You can find eight-lane highways in China that get 15 trucks a day or something," says Pettis. "You can find beautiful airports that only get a few flights a day."

Someone has to pay for these white elephants, and that someone is usually a Chinese banker. But the bad debts will wind up on the government's balance sheet eventually, Pettis says, just as they did in Japan, where net government debt has ballooned to more than double GDP.

More to the point, the projects are a sign that China's method of development—expand credit to build stuff to create jobs to create social stability—has played itself out. Pettis argues, persuasively, that China has little time to make the transition to a more balanced economy in which consumers, who currently account for just 35% of GDP, play a much larger role.

Assuming that the country makes that shift without a crisis, growth will still slow dramatically. Forget 8% or 9% a year. Think 3%. "Even if Chinese growth levels stay very high, we're moving…to a world in which investment will be growing much less quickly than China's GDP. That means those things that benefit from investment are going to suffer," Pettis argues. Like commodities—copper, cement and maybe even oil. For Canada, he says, "I think the implications are pretty ugly."