Macroscope | China’s wobbly economic recovery unlikely to become full-blown ‘Japanification’

For an indication of how quickly investor sentiment can deteriorate, look no further than China. The MSCI China index, which tracks Chinese stocks listed at home and abroad, was in the midst of a blistering rally at the start of the year, triggered by the unexpectedly rapid reopening of the country’s economy following three years of self-imposed isolation.

By early June, however, shorting Chinese equities was the second-most popular trade in markets, according to the results of Bank of America’s latest global fund manager survey published on June 13. Since peaking in late January, the MSCI China index has plunged more than 18 per cent, compared with a 4 per cent rise in the FTSE All-World Index, a gauge of global shares.

Concerns about the unevenness of China’s recovery have turned into deep misgivings about the underpinnings of growth and the timeliness and effectiveness of stronger monetary and fiscal stimulus. Morgan Stanley, one of a dwindling number of China bulls, said in a report published on June 20 that “we think it is fair to say without exaggeration that in our years of tracking China, investor sentiment has never been as bearish as it is now.”

This is partly because of mounting fears that China’s economy is suffering from the same malaise that plagued Japan following the bursting of its epic asset bubble in the early 1990s. To this day, that financial shock prevents the world’s third-largest economy from experiencing strong and sustained growth.

One of the most compelling analyses of what happened to Japan is the “balance sheet recession” concept pioneered by Richard Koo, chief economist at the Nomura Research Institute. This is when monetary policy becomes ineffective because highly indebted households and companies are focused on paying down debt and are reluctant to consume and invest, even when interest rates fall sharply.

Not only is there strong evidence that this phenomenon was responsible for Japan’s post-bubble stagnation and deflation, signs of such a slump were also apparent in the euro zone and the United States following the 2008 financial crash.