At the end of 1989, Japan’s bubble economy burst and its economic miracle came to an abrupt end. The Nikkei exchange fell from nearly 40,000 to its current 10,000 range. Over the course of 20 years, what appeared to be “unstoppable” economic growth proved to be anything but.
Today, China, in some ways, appears to be closer to following Japan than to sustaining its own economic miracle. China’s Shanghai Index (stocks) has fallen from a high of 7,000 in 2007 to a low of 2,000 for the past few years, and Chinese domestic investors have little confidence in their domestic stock market. The Japanese bubble, and its aftermath, was the result of a series of domestic financial and economic imbalances, many of which China faces today—to varying if not greater degrees:
º High growth rates fueled by credit-backed investment and artificially low interest rates
º Increasingly misallocated investment, which created unnecessary manufacturing capacity, and infrastructure and real estate development
º Reliance on large trade surpluses to balance excessive manufacturing capacity with low domestic consumption
º Runaway debt levels across the economy as debt growth outstrips servicing capacity.
Exploring similarities between Japan—in the run up to, and over the past two decades—and contemporary China is useful when trying to look a decade or two into the future to consider China’s fate.
Most significantly, China’s banking system mirrors Japan’s from the mid-1980s until Japan’s bubble burst. Both systems are arms of the state, which channel capital to fuel the “economic engine,” favoring corporate growth to the detriment of the consumer: Japan favoring the interwoven, collaborative Keiretsu model and China promoting the growth of State Owned Enterprises (SOEs).
Chinese banks, repeating the experience of their Japanese counterparts, have overseen a fourfold increase in total loan growth in less than a decade, driven mostly by property-related loans. Between 40% and 60% of total loan value in the banking system is backed by real estate in one form or another. System-wide reliance on real estate as collateral may be particularly pernicious given the meteoric rise of property prices in China and the central role real estate bubbles have played in recent financial and economic crises. Real-estate bubbles have been one of, if not the, common denominator of every financial crisis over the past 20 years, from the US savings and loan crisis and the Japan bubble, to the Asian Financial Crisis in 1997 and the most recent global financial crisis in the US and Europe.
Property prices in Japan and China, driven by speculation (supported by the banks), were pushed to unaffordable levels, limiting and in some cases prohibiting, middle-class homeownership in each country. Government policies favoring the construction industry created the problem as both countries tried to “grow their way out of the problem” by “paving over the countryside” with infrastructure developments.
I leave it to the political pundits to compare the 50-year rule of the Liberal Democratic Party in Japan to the 60-year reign of the Chinese Communist Party in China. But the strong similarities are undeniable.
In response to increasingly misallocated investments, Chinese banks have been “ever-greening” or rolling over loans as they come due for many years to avoid recognizing a growing non-performing loan problem. Both Japanese and Chinese banks became “masters” at using off-balance sheet techniques to hide their most risky loans. And “non-bank” financial institutions such as Japan’s leasing and finance companies and China’s Big Four asset management companies hide billions of bad loans, which the banks in turn allowed trusts to package and sell as wealth management products to their retail customers. Some analysts estimate that the “shadow banking system” (highly unregulated) now exceeds the official banking system and is plagued with high interest rate non-performing loans.
It is unlikely that China can continue to grow its way out of the problem through its familiar investment-driven model as debt-to-GDP will reach 206% by year’s end, according to Standard Chartered Bank. While China, similar to Japan, has no significant amount of foreign debt holders, the impact of such high debt-to-GDP ratios will be stifled growth.
China can no longer afford to spend massive amounts of stimulus monies to restore economic growth in excess of 8% per annum. The last wave of stimulus caused debt-to-GDP to skyrocket and inflation to spike. As local governments were led to the money trough, the result was endless infrastructure projects “too big to finish,” leaving local government debt—secured by pledging more land as collateral—accounting for more than 20% of every loan in the banking system. Local governments are now underwater and can no longer rely on land sales to developers to fund essential public services such as fire, police, schools, hospitals, and sanitation. The outlook is dire.
China’s new leadership is facing many challenges: corruption; environmental degradation in favor of industrial growth resulting in as many as 180,000 demonstrations; a property bubble when millions of unsold residential units are put on the market as property taxes and asset appreciation continues to wain; the spectre of trust and wealth management product failures forcing banks to bring these instruments back on their balance sheets; a social crisis over housing affordability; China’s inability to provide employment to the millions of migrant workers who leave rural farms in search of higher wages and a piece of the China Dream.
China’s growth model has created imbalances with immediate social, economic, and financial problems. The problems in China have become so large that it will be nearly impossible to continue to sweep them under the carpet (banks’ real ratios of non-performing loans, local government debts, social housing, unfinished inefficient grandiose projects such as Ordos Ghost Cities and Tianjin’s Manhattan skyline with 47 new high-rise towers under development are examples of the “trophy project” mentality that swept almost every Chinese city. Every problem has trillion-dollar implications.
China must re-balance its economy and start to favor the consumer—with higher deposit rates, affordable housing, investment in health care (hospitals), health services to an aging population, a social security safety net and important municipal services such as schools, libraries, sanitation and environmental clean-up.
China started to address these issues in 2000 when it began to reform the banking system, make the SOE’s more efficient and move from a planned economy to a capital/market-driven economy. Unfortunately, attempts to help the banking system move from SOE-centric crony capitalism toward a market-driven, cash flow-based model, failed miserably. Since then, China has gone back to its old ways of doing business and the imbalances have grown. The “old tricks” of the game and financial “slight of hand” are not likely to produce the necessary reforms or move the economy in the right direction.
The Japanese experience illustrates quite powerfully the inexorable requirement that imbalances be corrected. The question is not “if” but “when” and “what degree of control will leaders have over the rebalancing process?” Either Chinese leaders face the challenge head on and implement the policies necessary to rebalance the economy or continue to “pretend and extend” until the system collapses under its own weight. If the new administration chooses to embrace change and transparency at a slow but steady pace, you may see a China where growth moderates to 4-5% per annum. If leaders continue to “kick the can down the road,” the imbalance bubble will burst.
The recent economic history of Japan may provide another lesson for China. After the bubble burst in 1989, Japan spent the subsequent years expanding credit to support struggling financial institutions (mainly through government arranged consolidations), and businesses and industries in order to prevent more short-term pain. By propping up failed enterprises, the economic system was never fully purged. The result has been anemic growth and continued reliance on ever-less-effective stimulus (the Japanese economy contracted at an annual pace of 3.5% in the most recent quarter).
A lot has been written on the need to achieve high growth rates to maintain social and political stability in China. Chinese leaders may see 4% to 5% growth rates as a threat to their position but a greater threat is from the continuation of policies that expand imbalances, make adjustments more severe, and stifle long-term economic growth. If this situation were to materialize, moderate GDP growth would appear rosy.
The next six to 12 months should be telling for which way the wind is blowing in China.
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