China must avoid a Japanese-style bubble
Everyone agrees that China’s economy must be rebalanced, but few have bothered to delve into the costs. Japan’s experience has shown that even well-meant changes could sow the seeds for a bubble.
China cannot stay with its current economic model forever. But as the economy has become extremely unbalanced, to some extent even more so than Japan’s in the 1980s, rocking the boat too much risks tipping it over. Instead of rushing into changes, it would be better to make reforms gradually.
Most observers believe an extremely loose monetary policy was the root cause of Japan’s bubble. But Tomo Kinoshita, an economist at Nomura, reckons that efforts to liberalise the economy, such as sharply revaluing the yen, developing a deeper bond market and deregulating interest rates were among the fundamental reasons behind the bubble.
The challenges facing China’s economy are similar to those seen in Japan in the 1980s. Foreigners are calling for a currency revaluation because the undervalued yuan gives China’s exports an extra boost. Capital markets need to play a bigger role because investment has been directed mostly by state-owned banks.
True, property price increases appear to be milder than in the Japan of the 1980s. Household loans only account for 30 percent of disposable incomes in China, versus about 90 percent in Japan in 1989, according to Nomura. But there are warning signs. New mortgages recently hit a record. And ratings agency Fitch has cited China’s property market as a cause for concern.
The Chinese stock market also looks less overvalued than Japan’s did. The ratio of Chinese stock prices to earnings is only a third of the peak levels reached in Japan. Stock market capitalization as a percentage of GDP is 62 percent, much lower than Japan’s 150 percent at end of 1989. But China is catching up fast, and the ChiNext market, China’s long-awaited Nasdaq-style market, debuted last week with a speculative surge.
Moreover, China has been more aggressive in terms of monetary easing as it tries to prop up the economy while waiting for exports to return. The broad money supply in China has been rising at almost 30 percent this year, twice as much as in Japan back in the 1980s. So if there is a bubble, it could grow bigger than the one in Japan.
Even much-needed efforts to liberalise and rebalance the economy may lead to asset price inflation. Similar to China, Japan’s banks were too big and small companies had trouble getting financing. So developing a corporate bond market and encouraging banks to lend more to small firms was seen as a healthy change.
But policymakers underestimated the negative impact on banks. After Japan developed a liquid corporate bond market, large corporations issued cheap equity-linked bonds to repay bank loans. Because Japanese financial institutions lacked other revenue sources, they targeted smaller corporations and consumers. Total bank loans made to small- and medium-sized companies and individuals rose to 71 percent of total loans in the late 1990s from 47 percent in the late 1980s.
Due to a lack of information on their new clients, the banks’ bad loans started to rise. Their lending standards deteriorated as they scrambled to make up for lost business. This could very well happen in China as the country encourages consumers to take on more debt to stimulate domestic demand.
Moreover, Kinoshita argues that in Japan interest rate deregulation “put a cat amongst the banking pigeons” because banks were forced to lend out more when their margins became compressed due to more competition. Pressure from the United States played a role, and the Japanese authorities were eager to internationalize the yen anyway. Letting banks set deposit and lending rates was one of the requirements for the yen’s internationalization.
The policy lesson for China is that when Beijing takes business away from banks, it needs to balance things out by allowing them to take on new business, such as securities underwriting and broking.
But that leads to the question of how to compensate securities firms for their lost business and prevent them from engaging in reckless behavior. This just underscores the complexity of China’s problems.
Most of the world believes that China risks moving too slowly, not too fast. President Barack Obama might give Chinese leaders another ear bashing during his upcoming trip to China. But without the right systems in place, big bang reforms could be disastrous. It is important that China, as well as the rest of the world, learns from Japan’s mistakes.