China’s history is one of cycles – it unifies, it fragments, then it unifies again. The duration of each phase varies, as do the causes of each breakdown, but for hundreds of years the cycle has been reliable. The last devolution followed the European intervention in the 19th century, starting a period of regionalism in which strongmen effectively controlled parts of the country. The Chinese civil war, launched in the 1920s and culminating in the Communist victory in 1949, followed by Mao Zedong’s reign, marked the beginning of the current era of centralization.
Looking at China today, it’s plain to see that the likeliest cause of the next devolution – if there is one – will be financial. China has taken on an enormous debt burden so that it could support state-owned enterprises, which help prop up employment and economic growth. To be sure, China’s economic growth in this era of unity is unprecedented. But the consequence of its approach is an array of economic and political challenges – the problems China will have to overcome if it’s going to break the cycle of unification and fragmentation – of a magnitude that is equally unprecedented.
To try to predict how China will fare in its endeavor to avoid fragmentation, we look at a comparable and recent example, Japan: The Japanese economic crisis in the late 1980s and early 1990s set off the infamous Lost Decade (though in truth, nearly three decades later Japan is still trying to get out of its slump). Like China, Japan accumulated a lot of debt that was intertwined with its real estate industry, which had systemic implications for its financial system. Japan managed to hold together. Will China?
This Deep Dive will focus on the similarities and differences between Japan’s crisis and the one facing China. It will consider how their different political systems might affect their ability to initiate stimulus and implement reform. And it will investigate China’s earlier banking crisis from the late 1990s to the early 2000s to understand what tools China had at its disposal then, and whether it can leverage them again this time around.
China Now, Japan Then
China’s economic growth over the past four decades has been astonishing. Once a country dependent on agriculture, with near-ubiquitous poverty, it has been transformed into a modern industrial power with falling poverty rates. The sheer size of China, however, means that many people, especially those in rural areas, have not benefited as much as those in the coastal cities. In search of higher incomes, more than 260 million people have moved from the countryside to the cities for work. The result has been a major shift in the composition of China’s economy from being primarily based on agriculture to being overwhelming composed of industry and service sectors. In some ways, this process mirrors that of other industrializing countries, only China’s was largely state-driven and was on a grander scale.
Like most developing countries, China has a fundamental problem: It wants to transition to a consumption-based economy (which is more stable than relying on exports), but its domestic consumer base is not yet wealthy enough to support the level of economic productivity needed to allow for that transition. It has plugged the gap with exports – a vulnerability given that global demand will probably remain limited in coming years – and government-driven investment, resulting in a significant expansion of credit in China’s economy. Its debt grew after the 2008-09 global recession, when Beijing implemented a nearly $600 billion fiscal stimulus package to mitigate the severity of the crisis.
Depending on the source, China’s total debt (both public and private) to gross domestic product ratio is no less than 260 percent and potentially as high as 300 percent. Much of this debt is either directly or indirectly intertwined with the real estate market, which makes it a systemic threat to the financial sector should property prices drop precipitously. To get a handle on the situation before such a financial crisis materializes, President Xi Jinping has assumed vast new authority, placing him at the center of nearly all organs of state, and has begun to implement far-reaching reforms.
Japan’s circumstances were different – its economy had just been wrecked by World War II – but, like China, it rebuilt itself on exports. With the U.S. guaranteeing its security, post-war Japan could focus all its energy on constructing a modern economy. Also like China, Japan first competed on the international market by providing cheap labor for low-cost exports, gradually moving up the value chain to gain a reputation for high-quality manufactured products.
Japan’s economy started to liberalize toward the end of the 1970s and in the 1980s. For the first time, companies could raise money on the capital markets rather than depend entirely on bank loans. Suddenly, Japan’s large commercial banks weren’t making enough money on loans to corporations, and Japanese regulations prevented them from moving into complementary services like investment banking. Other aspects of liberalization drove up funding costs for large commercial banks. They began to undertake riskier lending practices, including more euro-yen borrowing and prime rate borrowing – both of which provided lower interest rate loans to small and medium-sized companies that previously would not have qualified. This put pressure on banks’ margins. Then, with larger banks targeting smaller companies than they normally would, smaller banks, which had previously catered to those small and midsized companies, also found their profits squeezed.
As competition increased, banks extended riskier loans. Maturity periods were extended, which increased exposure to liquidity risk (since the loans would not be paid back for longer periods of time) and interest rate risk (the risk that rates would increase but bank margins would be locked in low in pre-existing loans). Critically, both large and small banks began to seek new lending opportunities in the real estate market. The combined effect was an increase of debt, beginning in the 1970s in the public sector and continuing in the 1980s in the private sector, and an accompanying increase in land values and asset prices driven by the growing availability of credit to the real estate market.
Then things went from bad to worse. To combat high inflation, the U.S. raised interest rates in the early 1980s. This resulted in a large trade deficit in the U.S. that threatened to lead to protectionist measures, which would have done considerable damage to Japan’s and West Germany’s export-driven economies. So, in 1985, West Germany, France, Japan, the United States and the United Kingdom agreed to the Plaza Accords, which devalued the dollar relative to a number of other currencies, including the Japanese yen.
The result of the rapid devaluation of the dollar was a rapid appreciation of the yen relative to the dollar. The exports on which Japan’s economy depended became more expensive for its foreign customers. The resulting slump in exports led the Japanese government to introduce stimulus measures, which, in the late 1980s, began to add considerably to the country’s already large debt burden. By the end of the 1990s, Japan’s total private and public debt peaked at nearly 350 percent of GDP.
Similar to China’s current situation, new credit extended to the real estate sector generated a bubble in land values and asset prices. The Japanese government tried to deflate the bubble by implementing restrictions in real estate lending in 1990. This caused real estate and stock prices to fall rapidly, and real estate companies immediately saw decreased access to credit and a drop in the value of their collateral. Many banks had held reserves in the form of stocks, which put added pressure on the banks’ financial positions when the equity market bubble popped. Economic growth slowed, further undermining the ability of borrowers to service their debt.
All of these factors contributed to growth in nonperforming loans, the extent of which the Japanese government became aware only gradually between 1990 and 1994, when banks found themselves undercapitalized because of the decline in equity prices. Tokyo’s delayed recognition of the severity of the problem was one of the major factors that contributed to the extended malaise of Japan’s economy in the 1990s. The other was the government’s inability to convince the public to provide bailout funds for the banks until 1998, after several major banks began applying for government financial support and others had been ordered by the Ministry of Finance to suspend operations. There are many similarities in this story to what China is undergoing today – the dependence on exports, the stimulus that accelerated the growth of debt, the real estate asset bubble – but China has some advantages that Japan didn’t have. It also has some serious disadvantages.
What Sets China Apart
The comprehensive reforms being implemented by Xi are an indication that China’s elites understand the true magnitude of their problem in a way that Japan, for years, did not. The Chinese elites are willing, at least for now, to concentrate decision-making power with one man who can make the painful changes the country needs – ostensibly without getting mired in bureaucratic sludge. The Communist Party is aware of how much Chinese society must transform to reach a point of greater stability, and it does not intend to let paralysis or hesitation get in its way.
Even before Xi began implementing his most recent reforms following the October 2017 party congress, the government had made some strides in attacking its debt. As Chinese savers have sought higher yields than those from deposit accounts, they have invested ever-growing amounts in shadow banking assets, such as wealth management products, which offer a greater rate of return but are invested in riskier projects (often real estate construction). These have been a headache for the government, which for years has struggled to even understand the true size of the shadow banking market (WMPs are not actually carried on bank balance sheets, hence the term “off-balance sheet product”), let alone discourage their growth. But in 2017, Beijing introduced new regulations that reduced liquidity in the interbank lending market, including a nearly $550 billion decline in WMPs being sold and purchased between banks. That said, interbank WMPs account for only about a fifth of all WMPs, which themselves make up less than half of all shadow banking assets.
Another important distinction between China now and Japan of 30 years ago is their level of development. By the late 1980s, the eve of the Lost Decade, Japan was already a major industrialized country. China is still a developing country. Some regions have made tremendous progress, but much of the country is still quite poor, making China far more unequal than Japan was in 1990. Since many parts of China are still poor, it has not yet developed a robust domestic consumer base. As a result, consumer spending in China is a far smaller component of GDP than it was in Japan when Japan’s crisis hit.
It will be much more difficult for China to develop a consumer economy than it was for Japan – it has a much larger population, spread over a much larger area than Japan. But it is worth noting that China’s levels of investment fairly closely track those of Japan – and, as another point of reference, South Korea – at the same points of their development. Still, China’s investments as a percentage of GDP have diverged in recent years from the trend set by the other two countries.
There are two ways to look at China’s underdevelopment relative to that of 1990s Japan and how it may impact China’s ability to manage its economic woes. On the one hand, that so many people have failed to reap an equal amount of the rewards from China’s success means that, were a financial crisis to hit, people would hurt more in China than they did in Japan, making the country more susceptible to political agitation. Unlike in Japan, where leaders come and go and can be voted out, in China the Communist Party is the government. The only way to throw the bums out in China is to oppose the government itself.
On the flip side, that China arguably has significant growth potential left relative to what Japan had means that it may grow enough over the coming years – despite projections of slower growth – to overcome some of the financial challenges that could otherwise turn into political unrest. Gauging whether a country is poised for more growth is a difficult task, especially in China, where statistics always have to be viewed with a healthy degree of skepticism. One area that could provide some insight is labor productivity.
Increases in labor productivity can come from a number of sources, such as urban migration and technology. There’s a limit to how much urbanization and worker relocation can add to labor productivity, because there’s a limit to how many workers can leave agricultural jobs in the countryside to pursue industrial work in the cities. Eventually, technology needs to become the driver of increases in labor productivity.
Japan began industrializing in the mid-to-late 19th century, whereas China remained essentially an agricultural society until the onset of Deng Xiaoping’s reforms in the 1980s. Japan’s industrial base was destroyed in World War II and was subsequently rebuilt with U.S. assistance. By the ‘80s, Japan had an advanced economy with a large portion of its society living in cities and working in productive industries. Any further increase in labor productivity at this point would largely have to come from technological innovation. China, however, still has the low-hanging fruit of relocating capital and labor to more productive enterprises and regions. In fact, China’s labor productivity still lags 1980s Japan’s significantly.
Finally, it’s worth mentioning that, though asset and land prices have increased substantially in China, they are still not as large as the bubble experienced by Japan. Japan’s stock index, the Nikkei, grew by nearly 500 percent in the 1980s compared with the 90 percent growth seen in the Shanghai Composite since 2009 (though it did reach about 220 percent growth at its peak in 2015). Land and property values also increased more in Japan than they have in China. A direct comparison on that account is difficult, however, since the Chinese government technically owns all land and therefore can more easily restrict or increase the supply to property developers – though not without causing other problems.
Lessons From an Earlier Chinese Crisis
Yet another distinction between Japan and China is the nature of China’s political system itself. China’s handling of an earlier crisis is an example of the advantage inherent in its system. During the wave of liberalization in Japan’s financial system, banks had to offer higher deposit rates to appeal to capital that could more easily find opportunities abroad. The Chinese government, however, can intervene more directly in the capital markets, and it has been implementing strict capital outflow controls to prevent too much money from leaving the country. This could put pressure on sources of funding and risk an uncontrolled decline in the value of the yuan. China’s authoritarian political system provides it with a greater degree of control over the flows of money and its economy generally. Of course, aggravating an elite segment of the population trying to protect its fortunes by relocating part of them outside of China has political ramifications.
In the wake of China’s banking crisis in 1999, the government moved quickly to set up asset management companies (so-called bad banks) to purchase nonperforming loans from the big state banks, which were subsequently recapitalized. At the time, the financial system was nearly insolvent: NPL rates were estimated to be as high as 40 percent. Compare that to today’s level, where estimates of NPLs in the Chinese economy range from 8 to 16 percent. (The official rate is 1.74 percent, but even most Chinese authorities don’t believe that number.)
Five years later, the Chinese government was able to return banks to profitability by setting a ceiling on deposit rates. This ceiling, notably, was below the inflation rate at the time. Low deposit rates let banks lend to heavily indebted state-owned enterprises at low interest rates, minimizing their debt service burden while also providing a profit margin to banks.
But by requiring deposit rates to be set below inflation, the government was effectively forcing savers to incur a reduction in the value of their savings. Put another way, the government was seizing wealth from the Chinese people and distributing it to state-owned banks and companies to keep them afloat. At the time, the fledgling stock and bond market could not absorb the quantity of capital in the economy, and savers were therefore forced to hold their money in banks. The strategy worked. Chinese banks recovered profitability, which enabled them to undergo a series of initial public offerings to raise even more capital, and the economy kept humming.
This method of asset confiscation may not be available to Beijing this time around. In large part because of savers’ experience last time, a new market for non-banking products has developed that provides both a higher rate of return and, at least for a while, a place to park money that is out of sight of the central government. A large amount of Chinese savings is now placed in WMPs and other such vehicles, which minimizes the state’s ability to corral capital into traditional savings accounts and suppress deposit rates.
The Chinese government, however, has been taking real steps to increase transparency and control of the shadow banking market, and it is not unforeseeable that the government could force people to relocate their money into traditional savings accounts again. The government also hopes to at least minimize the “regulatory arbitrage” opportunities that gave rise to the growth of shadow banking in the first place. For years, China had distinct banking and insurance regulators. Banks and other financial institutions found gaps in the two agencies’ rules and exploited them to sell riskier but more profitable products to investors. Xi recently announced, however, that the regulatory agencies will merge and will be stripped of policymaking powers. The ability to set policy had given rise to interagency competition for oversight and led to a sort of race to the bottom to weaken regulations. Now, the central bank and the Financial Stability and Development Committee will set policy and the regulators will focus on enforcement.
Just because the previous way of seizing wealth may have lost some effectiveness does not mean the Chinese government couldn’t more directly take money from the rich to fund infrastructure development in rural areas and other means of redistributing the benefits of economic growth to the poor. In fact, this is a scenario that many wealthy Chinese are deeply concerned about. As a result, over the past several years, a sizable amount of Chinese capital has fled the country in search of hard assets abroad. This is also why even more capital controls were implemented over the past year.
China has a range of tools available to it, has been generally proactive about its financial problems, and, because of the consolidation of Xi’s power, will likely be able to move more rapidly on its debt problems than Japan could. Still, the magnitude of the obstacles that China must overcome should not be understated. China’s population today, about 1.4 billion people, is more than 10 times that of Japan in 1990. China is far larger than Japan, and far more unequal. Connecting so many people to the growing economy will require massive infrastructure investment that may be outside the scope of China’s funding capacities.
Just because Japan was able to convert from an investment-driven to a consumer-driven economy does not mean China will be able to. The countries’ demographics and size are different, but so is the timing: One of the most significant periods of growth in human history occurred in the latter half of the 20th century, when Japan was reindustrializing and establishing itself as a major value-added exporter. Today, prospects for global growth, and thus demand for Chinese exports, are much dimmer. If global demand slumps before China can achieve higher rates of consumption in its economy, and more people begin to suffer from a stagnant rather than a merely slow-growing economy, then the pain felt in China could sap support for further reform. Not to mention Japan is still essentially recovering from the Lost Decade. China, which lacks the wealth and standard of living that Japan had in the 1990s, may not be able to withstand a similar period of stagnation without slipping into the political instability that the regime so deeply fears.
Then there’s the data issue. China’s government is highly incentivized to manipulate growth figures. After all, slower growth could be a sign of coming hardships, generating political opposition to the Communist Party and endangering the country’s ability to complete its reforms and maintain stability. Just this week, Caixin reported that Chinese manufacturing growth had slowed because of lower export demand, while Chinese official statistics over the weekend said manufacturing growth in fact grew on increased domestic and foreign demand – essentially the opposite claim. There are also mounting examples of Chinese municipalities misreporting data to the central government, which makes it difficult for Beijing to know what exactly is going on in its provinces. This was a non-issue for Japan, which, even before its asset bubble burst in 1989, reported fairly reliable data. It was public data that led the Bank for International Settlements to require Japanese banks to shore up their capital reserves, in part forcing Japan to recognize the full extent of its banking problems.
There are also fundamental differences in what China is facing compared to Japan that go beyond economics. In Japan, although consensus on government action took a long time to materialize, once there was consensus the government moved quickly to rescue the failing banks. Xi’s purges are a sign that, in China, such a consensus doesn’t really exist. There are winners and losers, and though Xi has purged everyone who opposed him, his ability to maintain support from the elites if his reforms fail is a major question. In this sense, while Xi appears strong now, much of that strength comes from purges that both eliminated opposition and cleared a fair degree of corruption from the administrative bureaucracy, which the Chinese have generally sanctioned.
China’s violent history must also be taken into consideration. In the Meiji Restoration, Japan was able to undergo a sort of nonviolent, top-down revolution guided by the elites. This enabled Japan to industrialize extremely rapidly in the latter half of the 19th century. In China, it took a civil war spanning multiple decades, culminating in a bottom-up, peasant-led revolution, to even set the stage for economic development, which didn’t really begin until Mao died 30 years later. Within the past 150 years, there are no examples of Japanese domestic mass violence. In China, there are several.
China is in a race against time to complete a colossal restructuring of its economy. Complete success – that is, a smooth, nonviolent transition to a consumption-driven economy, without suffering an extended period of economic stagnation – seems unlikely given the scale of the challenges. But it would be a mistake to underestimate China’s ability to effect mammoth changes in the structure of its society in short periods of time.