Japan's economy shrank slightly in the final quarter of 2010 but analysts expect a recovery this year as stronger exports to China and other parts of fast-growing Asia offset persistently weak domestic demand.

The data confirmed Japan lost its place to China last year as the world's second-largest economy and highlighted Tokyo's increasing reliance on its giant neighbour, which buys nearly a fifth of Japan's exports.

Gross domestic product (GDP) shrank 0.3 per cent in the October-December period from the previous quarter, slightly less than a 0.5 per cent fall expected by markets but still the first contraction in five quarters.

That translated into an annualised contraction of 1.1 per cent, with analysts largely blaming the weakness on a temporary hit to consumption after the September expiry of government incentives to buy low-emission cars.

The data showed Japan's economy was the weakest among major rich nations, compared with annualised growth of 3.2 per cent in the United States in the same quarter. European data due out tomorrow is expected to show slight growth in the 17-nation euro zone.

The latest GDP figures confirmed analysts' estimates that China pulled ahead of Japan in 2010 as the world's second-biggest economy behind the United States on a seasonally unadjusted, nominal dollar basis, at $5.8786 trillion against $5.4742 trillion.

Economics Minister Kaoru Yosano said Japan needed to make the most of China's growth to boost its own fortunes, as it increasingly relies on demand from its Asian neighbour.

"The fact that China's economy is booming is welcome news for Japan as a neighbouring country," Yosano told reporters after the release of the data. "We want to deepen the amicable economic relationship between Japan and China."

Japan's shipments to mainland China accounted for 19.4 per cent of its overall exports last year, making it the No.1 destination for Japanese goods, followed by the United States at about 15.4 per cent.

The signs of an export-led recovery prompted the government to upgrade its economic assessment last month and dampened expectations of any imminent monetary easing by the Bank of Japan.

China raised interest rates last week for the second time in just over six weeks and further policy tightening is expected from Beijing in the coming months, raising the prospect of a slowdown in Chinese demand for everything from imported electronics to construction equipment and cars.

Reuters