Beijing may seem dynamic, but it’s heading down a path we’ve seen before.
November 4, 2016
China and Japan may seem to inhabit alternative economic universes. After more than two decades of stagnation, Japan is a fading global power that can’t seem to revive its fortunes no matter what unorthodox gimmicks it tries. By contrast, China’s ascent to superpower status appears relentless as it gains wealth, technology, and ambition.
Yet these Asian neighbors have a lot in common, and that doesn’t bode well for China’s economic future. The sad case of Japan should serve as a cautionary tale for China’s policymakers. Beijing pursued almost identical economic policies to Tokyo’s to generate its rapid development. Now China’s leaders are repeating the missteps the Japanese made that tanked Japan’s economy and thwarted its revival.
“Just like Japan, we believe China will eventually face a period of much slower growth,” Goldman Sachs investment strategists said in a report earlier this year. Analysts at ratings agency Moody’s, writing in May, warned that China could suffer “a prolonged period of sub-optimal economic growth and persistent deflationary pressures, or possibly even economic stagnation.” James Chanos, founder of fund manager Kynikos Associates, has compared China’s trajectory to Japan’s “on steroids.”
Some may disregard these warnings as the same predictions of doom that China has shrugged off time and again. But recall that 30 years ago, few foresaw the decline of Japan, either. Japan was the East Asian giant poised to overtake the U.S. as the world’s top economy. Driving that ascent was an economic system that many considered superior to laissez-faire American capitalism. By fostering close, cooperative ties among the state, big corporations, and banks, Japan’s policymakers encouraged investment and guided a national industrial strategy. Bureaucrats in Tokyo interfered with markets to a degree unthinkable in the U.S. by protecting nascent industries and directing financing to favored sectors and companies. Backed by such support, Japanese companies burst onto the world stage and pushed their American competitors to the wall.
But even as Japan appeared destined for greatness, its economy was, in reality, starting to rot. Those clubby ties among finance, business, and government misallocated capital and led to wasteful investments. Growth was given a boost by cheap credit in the second half of the 1980s, but that also helped inflate debt levels and stock and property prices. When this “bubble economy” burst in the early 1990s, the financial industry was flattened. Japan has yet to fully recover.
China could be hurtling down a similar path. The methods Beijing employed to generate rapid growth—directing finance, nurturing targeted industries, and promoting exports—are replicas of Japan’s. And since the state in China’s “state capitalism” plays an even larger economic role than Japan’s officious bureaucracy does, the Chinese government interferes with markets to a greater degree.
In China, the chummy government-business-banking triumvirate has led to excess steel mills, cement plants, and apartment blocks on a staggering scale. And Beijing’s policymakers have responded to overbuilding with a massive influx of easy cash to keep the old, sputtering growth engines spinning. The flood of yuan has fueled unstable spikes in asset prices, as it did in Japan. Last year stock markets in China escalated to nosebleed levels, only to deflate in a panicked crash. Now property prices in Shanghai, Shenzhen, and other major cities are rising so quickly that officials have stepped in to control them.
"Bubble-prone, debt-obsessed economies are likely to fail, no matter the circumstances."
Perhaps more dangerously, China’s loose money has also pumped up a mammoth increase in debt—like Japan’s in the 1980s. Ratings company Fitch shows that total debt relative to national output in Japan jumped almost 80 percentage points, to 275 percent from 1980 to 1989, on the eve of the country’s financial meltdown. The same ratio in China has risen steeply—more than 100 percentage points from 2007 to 2015, reaching 255 percent of its gross domestic product, according to the Bank for International Settlements.
There are economists who argue that China’s mountain of debt isn’t as risky as it appears. Since the debt consists to a great degree of loans made by state banks to state enterprises, the government is likely to step in and support the financial system. And because Chinese debt is almost entirely domestic and backed by massive savings, the financial sector is unlikely to fall prey to outside shocks.
The experience of Japan suggests otherwise. It, too, was a creditor nation with large trade surpluses and ample savings in the early 1990s, but that didn’t prevent a financial crisis. If anything, Japan is proof that a bubble-prone, debt-obsessed economy is susceptible to failure, no matter the circumstances.
Japan can provide China with a model of exactly how not to handle such problems. Rather than allowing indebted, struggling companies to fail, the Japanese kept many afloat with continued credit, debt-for-equity swaps, and other tricks. Such “zombie” companies drag down the economy to this day. To sustain growth, the government turned to artificial stimulus—deficit-financed spending on infrastructure and unprecedented printing of yen by the central bank. That managed to swell Japan’s total debt to almost four times its national output at the end of 2015 while failing to revive the economy. The meddlesome bureaucracy has never reduced regulation nor opened markets enough to spur competition, efficiency, and entrepreneurship.
Officially, China’s president, Xi Jinping, has embarked on a different course. He’s pledged to undertake a sweeping program of pro-market reforms that could shift the economy toward new sources of growth, scrub out excess and waste, and promote private enterprise. In practice, however, China is following in Japan’s footsteps. Despite promises to eliminate zombie companies, Beijing has kept them alive by flooding the economy with credit and state stimulus. In October government planners announced the details of a debt-for-equity swap plan ostensibly aimed at rescuing “good” companies, but more likely perpetuating excess capacity.
Meanwhile, China’s debt burden continues to get heavier, as the expansion of credit outpaces GDP growth. But that credit isn’t stirring the economy. As in Japan, a kind of paralysis is setting in that renders all that cash less effective. There are indications that more and more new credit is being used just to pay off old debts. That means less and less money is going toward investment that could boost the economy.
China and Japan also share one long-term trend that hampers their economies—aging. Japan’s working-age population decreased 0.4 percent per year from 1990 to 2015. That hurts growth because fewer productive, income-earning workers are supporting a larger army of retirees. As a result of China’s decades-long policy of limiting many couples to only one child—a restriction Beijing eased only over the past three years—the Chinese population is set to age even more quickly, with the workforce expected to shrink nearly 0.5 percent annually over the next 25 years, according to Goldman Sachs.
Fortunately for China, nothing in economics is inevitable. Xi and his policy team can still swerve off Japan’s course if they more forcefully implement the reforms they’ve promised. Until then, the risks that China will become like Japan will only mount. Beijing and Tokyo have suffered from the same fatal flaw: a deep-seated unwillingness to alter a growth model that no longer delivers results.
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