After decades of emulating Japan’s export-driven economic miracle, China appears in danger of following it into the same kind of economic coma that Japan is trying to wake up from 20 years later.
China is struggling to wean itself off a habit picked up from its more advanced neighbour: relying for growth on exports and credit-fuelled investment. That has left its economy lopsided, economists say, with massive over investment in property and industries rapidly losing their cost advantage, from mining and electronics to cars and textiles. Wages are rising, the return on investments falling.
With growth slipping, China’s President Xi Jinping and Premier Li Keqiang seem determined to avoid a US-style financial crisis, complete with widespread bankruptcies and job losses.
Preventing such a crisis though could embalm diseased sectors, stifling efforts to make growth more sustainable and instead create the kind of “zombie” banks and companies that sucked the life out of Japan’s economy, economists say.
Add a population greying faster than Japan’s did, and economists worry China may be attempting the impossible.
“There is a huge amount of denial. People think that demographics don’t matter,” said Chetan Ahya, chief Asia economist at Morgan Stanley in Hong Kong. “I’m worried about the deflationary risk.”
Deflation may seem unlikely in an economy still growing at a 7.5 per cent clip and where consumer prices are rising 2.7 per cent a year. But economists warn that China in many ways resembles Japan in 1989, two years before its crash.
Like Japan, China relied on banks to funnel investment into export industries to create jobs and finance development. In return, interest rates were regulated to ensure banks a healthy profit. Because the most profitable loans were those to the least-risky borrowers, banks concentrated their lending on big state-owned companies.
As Japan did in the 1980s, China tried to remedy this by partially liberalising the financial sector, creating new avenues of finance, a bond market and other non-bank lending. But as in Japan, this encouraged banks to lend more, not more wisely, helping fuel a property bubble. Things got worse in 2009, when China launched a 4 trillion yuan (HK$5.0 trillion), credit-powered stimulus to ward off the global crisis.
While Japan saw credit expand from 127 per cent of GDP to 176 per cent between 1980 and 1990, China’s credit rose from 105 per cent in 2000 to 187 per cent of GDP last year, JPMorgan Chase in Hong Kong says.
China’s problem now is that each yuan of new investment is yielding a diminishing amount of new GDP. The slowdown is already creating signs of deflationary pressure: producer prices have been falling for 16 months and Morgan Stanley notes that real borrowing costs of 8.7 per cent are outpacing the sector’s growth.
One risk, therefore, is that China’s reforms push growth low enough to trigger a wave of defaults that shakes the entire financial system.
“It’s very important to slow down the growth of credit,” said Grace Ng, senior China economist at JP Morgan in Hong Kong. “But if we slow and de-leverage too much you could have too much downside risk on the real economy.”
The bigger risk, she and others caution, is that to avoid social unrest Beijing refuses to tolerate such pain, instead encouraging banks to keep troubled borrowers afloat by rolling over their loans like Japan’s banks did in the 1990s, preventing them from lending to profitable new ventures that could revive growth.
Beijing’s recent efforts to blunt the slowdown are thus drawing mixed reviews. Last week’s announcement by Premier Li that Beijing would cut taxes on small businesses and red tape for importers is seen as welcome restructuring, while boosting credit for foreign trade and speeding up railway investment smacks of mini-bailouts.
Likewise, some economists saw the central bank’s move this month to eliminate a floor on lending rates as a positive step towards making banks price loans according to their risk. Others saw Japan-style “regulatory forbearance,” a way to help banks refinance loans for their best customers so they can pass the savings to needier borrowers of their own.
“Since profit margins will be cut, banks will try to increase lending volumes by reducing their credit standard,” said Wataru Takahashi, a former Bank of Japan official who is now a professor at the Osaka University of Economics. “This is the story of the Japanese banks in the late-1980s.”
Some economists caution against exaggerating the similarities. “Comparing it to Japan in the 1990s is a little bit too much,” said Changyong Rhee, chief economist at the Asian Development Bank in Manila.
China’s lower development, Rhee and others say, gives it a reservoir of demand that affluent Japan did not have. China’s poor, inland provinces do not suffer from overcapacity and it will not take long before China needs the infrastructure projects that now might look like white elephants.
China’s push to move more citizens into its cities represents another source of growth.
But lower development also makes it harder to weather weak job growth or stagnant wages. And urbanisation may not be as potent as it once was: with more than half of China already in the cities, the median age in rural areas is roughly 40, not a demographic prone to relocating for new career opportunities.
Ultimately, it may be demographics that put China most firmly on Japan’s deflationary trail. Thanks to its one-child policy, China’s working age population is already shrinking. That’s what happened to Japan in the 1990s, resulting in lower consumption and sharply lower growth rates.
The solution may lie - where else - in Japan, where the government is fighting deflation with aggressive new policies to lower borrowing costs, by boosting government spending and, though it has implemented few of them yet, by removing bottlenecks to growth.
“Two things are needed to avoid deflation after a credit binge,” said Ahya at Morgan Stanley. “One is good fiscal and monetary response and the second is structural reforms.”