China is similar to Japan in the 1980s in terms of financial imbalances and challenges for the real economy, but, as JPMorgan notes, China differs in terms of its stage of economic development. Turning possibility into reality is not an easy task, especially as China’s structural slowdown is accompanied by mounting financial imbalances. In the near term, overcapacity and decline in the rate of return on investment are the major challenges to be addressed by policymakers, and rising debt in the corporate sector and local governments needs to be contained and gradually reduced. In our view, this would require reform not only on the economic front (e.g., fiscal reform, land reform, financial reform, and SOE reform), but also social reform (e.g., hukou reform) and governmental reform (e.g., changing the role of the government and de-monopolizing). The list of tasks is daunting, but policy inaction could be even more dangerous - a delay in economic restructuring in China could lead to a repeat of Japan’s experience.
How Similar Is China To Japan In The 1980s?
- China is similar to Japan in the 1980s in terms of financial imbalances and challenges for the real economy
- But China differs in terms of its stage of economic development
- Policy actions matter; a delay in economic restructuring in China could lead to a repeat of Japan’s experience
The liquidity squeeze in the interbank market in June has raised concerns over financial risk in China, and given the structural economic slowdown, how it will evolve in the coming years. China has experienced rapid credit growth and house price inflation in the past four to five years that would likely have engendered severe financial stress in other countries. Allowing this to continue could lead to a financial crisis; tightening credit and forcing deleveraging should slow growth to a more sustainable pace but risks a faster-than-desired slowdown. This is the dilemma facing Chinese policymakers.
The current situation in China is somewhat similar to Japan in the late 1980s. In Japan, the 1980s were followed by the “Lost Decade” of the 1990s: real GDP growth slowed from an average of 5.1% in 1985-89 to 1.2% in 1991-2000. Land prices collapsed. No systemic financial crisis occurred, but financial stress was hidden in the form of evergreen loans, zombie companies, and zombie banks. This raises the question: will China repeat Japan’s experience in the 1990s?
The similarities between China now and Japan in the 1980s
We look at the similarities between China now and Japan in the late 1980s in three broad areas: financial imbalances, challenges for the real economy, and the possibility of policy mistakes. We find that there are enough similarities to generate some concern, but also significant differences. On the financial side, both countries observed strong credit growth and asset price inflation, with corporate sector debt rising to a dangerously high level.
Using a broad concept of credit, the credit/GDP ratio in China rose from 105% in 2000 to 187% in 2012. This is similar to Japan’s experience, when the credit/GDP ratio (a narrower credit measure) increased from 127% in 1980 to 176% in 1990. Looking at the pace of growth, China’s credit growth in the past four to five years is more remarkable than that observed in Japan in the 1980s. In particular, total social financing (volume) as a percentage of GDP rose by 56%-pts just in the four years between 2008 and 2012.
In both countries credit growth was accompanied by rapid house price inflation. In China, real house prices (adjusted by CPI inflation) rose by an average of 8.9% in 2006-12. Similarly in Japan, real house prices rose by an average of 6.6% in 1986-90. To some extent, the housing affordability problem is more severe in China currently than in Japan in the 1980s, as China’s average household income is much lower (which also has led to social dissatisfaction).
Also, corporate debt increased to dangerously high levels in both countries. Based on our calculation, corporate debt in China rose from 90% of GDP in 2007 to 124% of GDP in 2012. In Japan, corporate debt increased from 95% of GDP in 1985 to 115% of GDP in 1990 (and further to 123% of GDP in 1993). A large portion of corporate debt is collateralized by land or property, which, if property values fall, can lead to a downward-spiraling interaction between declines in property values and corporate stress.
On the real economy side, China is facing similar challenges to Japan, in particular the change in demographic structure and the end of export-driven growth, which contributed to a structural slowdown in both economies.
First, the size of the working-age population (aged 15-64) started to decline in China in 2011, and the ageing of the population is intensifying. The share of the population 65 and above in China was 9.1% in 2011, and, by our estimates, will increase to 16% by 2020. These changes in demographic structure and working age population are similar to those that took place in Japan in the early 1990s.
Second, both China (in the past decade) and Japan (in the 1980s) benefited from export-driven growth. China’s export share of total global exports rose from 4% in 2000 to 11% in 2012, surpassing the peak level in Japan (9.8% of global exports in 1986). But the room for further expansion in exports in China is limited, and rising production costs (labor, land, and environmental protection) are hurting the competitiveness of the export sector.
Despite the mounting financial imbalances and economic slowdown, there are mitigating factors that could help China avoid an economic hard-landing that could be accompanied by a financial crisis. For instance, the increase in debt is mainly held by domestic investors, while foreign debt is relatively low (at about 10% of GDP); the national savings rate is very high (exceeding 50% of GDP); the current account surplus and large FX reserves provide a cushion against possible adverse shocks. Interestingly, these mitigating factors also existed in Japan in the late 1980s.
The presence of these factors has engendered a third concern—that they could lead to complacency by policymakers. Policymakers could conclude that without the immediate risk of a financial crisis, and if the economy can maintain the growth rates of the past, financial imbalances could be gradually reduced in the coming years. Such a misperception may cause regulatory forbearance and a delay in economic restructuring. Japan made such policy mistakes in the 1990s. If China repeats these policy mistakes, it could experience some of the same fallout as did Japan. But the consequences could be more severe for China, as China is not as wealthy as Japan was and so would not be able to sustain as much stress as the Japanese economy did in the 1990s.
What is different?
China today is not exactly the Japan of the 1980s. Indeed, in some respects (especially in terms of economic development), China is more similar to Japan in the 1960s and early 1970s.
First, despite the impressive growth since 1978, China’s GDP per capita is still only just above US$6,000. This is similar to Japan in 1977. In addition, China’s average growth in 2001-12 was 10.1% ar, similar to Japan’s average growth of 10.4% in the 1960s.
Second, in terms of economic structure, primary industry now accounts for about 10% of GDP in China. This is similar to Japan in the mid-1960s.
Third, the urbanization ratio is still relatively low in China. The urbanization ratio in China first moved above 50% in 2011 and was 52.6% in 2012, similar to Japan in the early 1970s. However, the actual urbanization ratio is much lower, as this figure includes about 220 million people who now live in urban areas but do not have household registration (or “hukou” in Chinese). This “semi-urban” population does not have access to the same privileges (medicare, education, pension, housing, etc.) as do other urban residents. Assuming that the share of China’s hukou population rises to 65% in the next two to three decades, this implies that a total of 440 million people (including the semi-urban and rural population) will settle in urban areas. This would create huge potential demand on the domestic front (both investment and consumption) and is the key factor to support China’s growth potential.
Fourth, although China’s demographic structure is similar to Japan in the early 1990s, the employment structure is very different. Non-agriculture employment accounted for only 66% of total employment in China in 2012. By contrast, in Japan the share of non-agriculture employment has stayed consistently above 90% since the mid-1970s. That means that in China the decline in the working age population does not necessarily lead to a labor deficit, as the transfer of employment from the agriculture to non-agriculture sector still provides a buffer in dealing with further increases in labor demand in non-agricultural sectors.
Fifth, although elevated corporate debt in China is similar to Japan in the 1980s, the household balance sheet is still healthy. Household debt (mainly mortgage loans and consumer loans) is only 20% of GDP in 2012, which is similar to Japan in the early 1970s and much lower than in other countries. This means that whatever stress emerges will mainly pressure the corporate sector; in the event of house price declines, the stress is more likely to impact corporate and local government sectors than to generate a sharp rise in mortgage delinquencies.
The comparison of China and Japan in the early 1970s points to another similarity. Throughout the 1970s, Japan’s economic growth slowed but maintained a solid pace of around 5%, and GDP per capita rose from below US$2,000 in 1970 to more than US$9,000 in 1980 (and further to about US$24,000 in 1989). Japan clearly emerged from the middle-income trap during the 1980s—still a goal for China.
Policy action is the key
Whether the similarities noted above between China and Japan continue in the near term depend critically on the actions taken by Chinese policymakers in the coming years.
Japan’s experience in the early 1970s suggests that China is likely to grow at a slower but still a decent pace of 6%-7% for the rest of this decade (see our Special Report “China’s growth trend to slow below 7%,” February 1, 2013). Urbanization is key for future growth. But in our view, two transitions are critical to China’s economic restructuring efforts.
The first is technological innovation and industry upgrade. In the past decade, China has gradually moved up the production ladder, from low-end production to manufacturing electrical equipment and high-tech products. There is still room to move up to the high end of the production ladder, like Japan did in the 1970s and 1980s.
The second is more balanced growth across the region. China is a large country, and the stage of development differs considerable across regions (see our research note “China: going inland,” March 11, 2012). GDP per capita reached US$9,000 in Eastern China in 2012, but was only about US$5,000 in the central and western parts of China. Although production costs have generally increased in China, there is sufficient room for industry relocation within the country (rather than moving outside of the country as happened in Japan).
Turning possibility into reality is not an easy task, especially as China’s structural slowdown is accompanied by mounting financial imbalances. In the near term, overcapacity and decline in the rate of return on investment are the major challenges to be addressed by policymakers, and rising debt in the corporate sector and local governments needs to be contained and gradually reduced. In our view, this would require reform not only on the economic front (e.g., fiscal reform, land reform, financial reform, and SOE reform), but also social reform (e.g., hukou reform) and governmental reform (e.g., changing the role of the government and de-monopolizing). The list of tasks is daunting, but policy inaction could be even more dangerous.