There was a time in the 1960s when, following many years of very impressive growth, the bet was on the Soviet Union overtaking the US to become the world’s largest economy. But Soviet central planning could never deliver the goods and so the USSR fell behind economically and later disintegrated politically.
Some 20 years later, the bet was on Japan overtaking the US. That too didn’t happen due to the massive debt-fuelled asset bubble Japan had got into. More recently, the betting was on China and it seemed to be a much surer bet. But recent headwinds have laid bare many of China’s problems, several of which seem deep-seated.
The irony is that China seems to have taken the same route that both Japan and the US had been on and stumbled. Growth on steroids funded with debt, leading to massive asset bubbles, mainly in the property sector. It was precisely the bursting of the property bubble that had brought both superpowers, Japan and the US, to their knees. There appears to be something tantalising about debt-fuelled growth that policymakers, capitalists or communists alike, cannot seem to resist.
China is today facing its most serious economic challenge since undertaking liberalisation more than 40 years ago. Growth has reduced sharply, the property bubble has burst, many property firms have or are on the verge of defaulting. The property sector, a quarter of its gross domestic product, is now in its third year of problems, and it only seems to be getting worse.
The negative wealth effect this has on household sentiments should not be underestimated. Its stock market has seriously underperformed relative to other markets, and there is a mountain of debt causing financial distress especially among local governments and the shadow banking sector. Asset management firms with investments in property/construction-related paper have been hit, consumer spending and confidence have weakened and, most worryingly, deflationary pressures seem evident. The Producer Price Index has now been falling for 10 months in a row. Add to these a rapidly ageing population and the situation is eerily similar to Japan of the early 1990s. But, China’s problem with an ageing population has occurred at a much lower per capita income level than Japan’s.
The central bank, the People’s Bank of China (PBoC), has come under pressure to stimulate further and faster than what it has done, including using quantitative easing (QE). Thus far, the PBoC seems circumspect, which is a good thing. The emphasis should be more on thought and well-planned action than mere quick action.
Since both Japan and the US have been through similar debt-induced crises, there is much that Chinese policymakers can learn from their experience. Interestingly the policy response and outcomes in both countries had been quite different. Where Japan has had to suffer nearly three lost decades of stagnation and depression-like conditions, the US recovered strongly within a couple years.
Japan, which had been growing at double-digit rates over the 1960s, 1970s and 1980s, hit a brick wall in the early 1990s. Heady growth had fuelled massive asset bubbles, particularly within stocks and real estate. The Nikkei 225 stock index, which was near 1,000 points in early 1960, went up steadily over the next 30 years to peak at 39,000 in December 1989. The stock market bubble burst first, followed by properties. The Nikkei fell just as steadily as it had earlier risen to hit 8,300 points in early 2003. Over the next three decades from 1990, there was massive value destruction. Real estate values fell an estimated 70% while stocks fell by 75%.
These are massive losses by any measure and the fact that they occurred over a long period points at policy ineffectiveness. Japan lost nearly three decades to economic stagnation and deflation.
The Japanese experience is in stark contrast to what happened in the US with the subprime crisis. When the US housing bubble burst in mid-2007, policy reaction was quick and tough. The crisis, like that in Japan, was deep-seated. The bursting property bubble caused such widespread damage that America’s largest firms, the likes of GM, Chrysler, AIG and its largest banks were left teetering. Yet, the US economy recovered strongly — following two years of declines in 2008 and 2009, GDP growth was already positive in 2010, a V-shaped recovery.
The difference with Japan was that in addition to the standard fiscal and monetary expansion, including the first time use of QE, the US undertook tough and painful measures. Apart from Bear Sterns and Lehman, hundreds of other banks were allowed to collapse. Surviving banks were forced to recapitalise, having carved out and written down their toxic mortgage assets. Thousands of businesses closed and unemployment went to a historic high of 10%. There was blood on Wall Street and on Main Street America, but the pain seemed to have paid off. The cleansing was deep and many of the bad behaviours and perverse incentives that led to the crisis were curtailed.
With hindsight, it appears that Japanese policymakers simply did not have the political will to undertake the painful measures the US had taken. Perhaps, as its crisis came much later, American policymakers, having seen from Japan what inaction can do, acted much more aggressively. The banking and business collapses and the restructuring seen in the US did not occur in Japan and, if at all, only superficially. The Japanese approach was to use massive monetary and fiscal expansion, with heavy emphasis on monetary measures. In the process, the Bank of Japan (BoJ), pioneered so many monetary initiatives the world had never seen previously, QE, yield curve control and the like. It was also among the first central banks to experiment with zero interest rates. Japan has gone through zero, negative and near zero interest rates for more than 20 years.
Clearly, the policy choice in Japan was to use the easier and much less painful measures. But it came at a huge cost. Without the painful restructuring, not only did Japan not recover but continued to straddle the bottom for years on end. It underwent serious deflationary pressure, a classic liquidity trap and lost much of its industrial prowess and mojo. While the fiscal expansion simply ended up as additional household savings, the years of monetary expansion kept alive businesses and banks that should have collapsed. The result was zombie banks and businesses living off the policy largess. Where previously, Japan’s industrial innovations like the JIT (just-in-time inventory) and QCC (Quality Control Circles) processes had dazzled the world, the BoJ’s innovations left the world puzzled. Puzzled by the continued reliance (on monetary policy tools) despite their doubtful effectiveness.
Yes, there were huge differences from a currency viewpoint between Japan and the US. The Plaza Accord’s restrictions on the yen did not help Japan with its crisis, whereas the dollar being a reserve currency gave the US much-needed space. But it should be noted that the seeds of Japan’s problems were sown years before the Plaza Accord’s restrictions.
As for China, there are still many factors favouring it. Most importantly, the banking sector remains strong and the PBoC has many options available. Though the problematic numbers may look huge in absolute terms, as a per cent of the overall government budget, they are manageable and while local governments may be strapped for cash, the central government has plenty. Further, China still remains globally cost-competitive with its highly advanced manufacturing base intact. Still, the country needs to face its problems with debt head on. The lessons from Japan and the US are clear. Some fiscal and monetary expansion is necessary for immediate relief but the painful restructuring must happen. The shadow banking sector has to be cleaned up and going forth, streamlined and better regulated. The excesses in the property sector may require a US-style Troubled Asset Relief Program initiative. A superfund may be needed to take over the distressed property firms and force their absorption into new state-owned entities tasked with rehabilitating and completing the projects and handing over finished units to their purchasers. This should help restore consumer sentiments and confidence.
As it currently stands, China’s three main problems are with debt, demography and diplomacy. There may not be much it can do on demography, at least not in the short term, but it can lower the temperature on issues with the West, be more pro-business and work seriously on reducing its debt.
Given China’s global footprint, a hard landing will have huge consequences for the world, particularly the developing nations of Asia. More than merely overcoming its current crisis, China must undertake the reforms needed to wean itself off debt-fuelled growth even if it means slower growth and pain in the short term. Whether the current crisis turns out to be a mere blip on China’s growth record or one that permanently alters its trajectory away from global dominance will depend on its policy choices.
Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University
This article first appeared in Forum, The Edge Malaysia Weekly on September 11, 2023 – September 17, 2023 (https://theedgemalaysia.com/node/682027)