China isn’t about to have a Japan-style lost decade
‘Policy pragmatism and willingness to embrace structural changes are, in our view, the fundamental differences between China today and Japan in the early 1990s’
In the previous instalment of our China end-game series, we outlined three possible paths for China to unwind its structural imbalances and that a financial crisis, akin to the US’s 2008 experience, is unlikely to happen due to China’s impeccable state control of its macro system. The latter has enabled China to kick the can down the road further than most countries when it comes to dealing with structural impediments.
However, merely suppressing the imbalances without ever resolving them cannot be a sustainable strategy. Without a crisis that cleanses the system, China may eventually have to pay a higher price.
To see what could be the cost for delaying the adjustment, we think Japan’s experience may contain some valuable insights.
Similar to China in recent years, Japan had witnessed significant asset price appreciation in the late 1980s, fuelled by easy monetary policy. The Plaza Accord, signed in 1985, ignited the strength in the Japanese yen, which eroded its export competitiveness. The working-age population peaked in 1992 and led to declining potential growth thereafter. Limited market clearance of zombie companies was a hallmark of Japan’s subsequent lost decades. The fiscal rescue, which failed to revive growth, had contaminated the official balance sheet, making Japan the most indebted government ever since.
There are eerie parallels between China and Japan, and the experience of lost decades warns that the cost for China’s can-kicking strategy could well be a collapse of its economic growth that eventually sinks the economy into a prolonged stagnation.
But are these similarities enough to support a firm verdict that China’s future is doomed? A deeper look at the Japan to China comparison casts some doubts.
First, even though China has experienced rapid asset price gains in recent years, the magnitude of them is nowhere near as large as that seen in Japan in the 1980s. In equity markets, the Shanghai Composite rose by only 80 per cent since 2009, dwarfed by the five-fold surge in the Nikkei in the late 1980s. Price increases in China’s property and land markets were also timid, compared to those seen in Japan over this period.
Second, while China’s population cycle has turned, the pace of ageing is still decades behind Japan’s. To reach Japan’s peak level of working-age population, China will have to wait until 2025. All else being equal, a slower deterioration in demographics will place less pressure on China’s potential growth and economic competitiveness.
Third, even though both countries have experienced foreign exchange regime changes, the respective results were completely the opposite. Following the Plaza Accord, the Japanese yen went on a relentless climb, surging 50 per cent against the US dollar and close to 30 per cent in real effective terms. Such an appreciation had undermined Japan’s exports and prompted the Bank of Japan to ease policy, which fuelled a gigantic asset bubble.
In contrast, China’s foreign exchange regime change in 2015 has led to a depreciation in the yuan. A weaker currency, should it continue, will support China’s exports and inflation, counteracting some of the negative adjustments internally.
Fourth, China today is at a very different stage of economic development than Japan in the early 1990s. While the latter was already a wealthy and advanced economy, China remains a developing country today. Its current level per-capita income and productivity is in fact close to that of Japan in the 1960s. This means that China still has significant catch-up potential left in its economy – something that Japan had already exhausted by the time of its crisis.
Lastly but not least, a critical factor that differentiates China and Japan is the differing attitudes of the two governments in dealing with asset bubbles. In Japan, asset bubbles had reached unprecedented scales partly because of policymakers’ reluctance to deflate them earlier. Moreover, they made colossal mistakes in managing the after-effects of the bubble-burst by failing to undertake reforms to remove zombie companies, clean up the banking system and rebalance the economy. Had the authorities avoided these mistakes, Japan might stand a chance of escaping the decades-long economic stagnation.
Such a fate is what Beijing is seeking to avoid. A two-pronged strategy has featured prominently in China’s systemic-risk management, where the authorities have been pragmatic in pricking bubbles (the interbank market in 2013 and 2016, housing market in 2014 and 2017, equity and foreign exchange markets in 2015), followed by a concerted effort to manage their subsequent spill overs.
Borrowing an analogy from the global financial crisis, one may say that Beijing is not afraid of having Bear-Stearns failures, but it is doing everything it can to avoid a Lehman collapse.
Complementing the cyclical policies, Beijing has also been undertaking reforms to resolve the deep-rooted imbalances. Clear progress has been made in areas of market liberalisation, overcapacity reduction, financial deleveraging and business deregulation.
This policy pragmatism and willingness to embrace structural changes are, in our view, the fundamental differences between China today and Japan in the early 1990s. Should the official policies continue to redirect the economy onto a more sustainable path, we think China stands a good chance of avoiding Japan’s fate of falling into a lost decade.
Aidan Yao is senior emerging Asia economist of AXA Investment Managers