A Sobering Anniversary

By Roy C. Smith

Amid the holiday bubbly, some will recall that 25 years ago, on December 29, the Nikkei index stood at 38,916, its all-time high. What happened next has sobering lessons for China. The bubble burst in a most non-festive fashion – and it had been inflated by government efforts to stave off exactly the problem that besets China today.

The Japanese babaru keizai, or “bubble economy”, of the 1980s resulted from efforts to sustain the “miracle growth” that began in the 1950s and won Japan its reputation as an economic superpower. After two decades of export-fueled growth, in the middle of the 1970s, Japan had started slowing towards a world average growth rate. Japanese officials sought to counter the trend with large amounts of easy money.

The ensuing “excess liquidity”, which reached 5.5% of GDP in 1986 and 1987, did not pass into goods and services as inflation but into rising prices of stocks and real estate. At the market’s peak, stocks in the Nikkei index traded at an average of 70 times earnings. Japanese institutions, corporations and households (and many foreign investors) all bought these assets, very often with borrowed money, because of their belief in the limitless sustainability of Japanese economic success. The Nikkei index rose six-fold in the 1980s, compared with a three-fold increase in the US stock market.

Then came the crash. As the Nikkei dropped 63% to a low of 14,309 in 1992, it sucked the value out of all other financial assets and collapsed the financial system that had taken the assets as collateral. The Nikkei continued to slide for 17 years, reaching a low of 7,055 in 2009.

Though the bursting of the Japanese bubble was nastier than most, bubbles do come and go. What is most frightening about the Japanese experience is the extent to which the confidence of the Japanese people in their economy was destroyed. Despite 25 years of Keynesian stimulus programs (that have pushed Japan’s government debt to GDP ratio from 50% in 1989 to 250%, the highest in the world), and a decade of zero-interest rate monetary policy, Japan’s average annual growth rate since 1990 has been scarcely above zero.

China is the “miracle economy” of today. It has much in common with the centralized, export-led economy of Japan before 1990. And it is vulnerable to similar sorts of asset bubbles that can devastate its economic momentum and progress.

Indeed, China was just getting started when the Japanese market blew up. Though China’s slow but steady opening up to Western markets was set back for a couple of years by the Tiananmen Square massacre – seven months before the 1989 Nikkei crash – Deng Xiaoping’s persistence in discarding Communism for “socialism with Chinese characteristics” led to 20 years of growth at an average rate of 9.5%

China’s basic economic strategy was the same as Japan’s: use a tightly controlled banking system to leverage the country’s high savings rate to finance plants and equipment that can manufacture high-quality, low-cost goods to be sold abroad for foreign exchange. Force overseas companies wanting access to the Chinese market to provide foreign direct investment and the latest technology, and gradually move manufactured products up the technology curve. Open and liberalize stock markets, privatize state-owned companies and let the world buy into the show as China breaks through (as it has) to become the world’s largest economy based on purchase-power parity.

The Shanghai Stock Exchange Index rose gradually after reopening in 1990 from 1,000 to 2,000 in 2001, after which, reflecting world equity markets, it slumped to about 1,500 in 2004. Then it jumped four-fold to 6,000 in 2007, only to be brought back to the 2,000 level after 2008. The index has not grown much since – losses may have driven away early believers, deflecting speculative demand into real estate. China’s stock market still lacks a broad institutional base of pension funds, insurance companies and mutual funds. As these develop, the demand for stocks will increase substantially. Today, China’s combined stockmarket capitalisation is about the same as Japan’s.

But, after 25 years, China’s growth rate is slowing and creating political headaches for its new government. Much of the slowdown reflects low growth in China’s exports but some is because of rising wages and operating costs in China, where economic and social expectations have risen. Disappointment in these expectations, or with local or regional political factors, may have been behind the 180,000 incidents of social unrest in 2010, estimated by The Economist.

China’s existential problem is that if economic growth drops below 7% or 8%, factory closings, unemployment and social demands could threaten Party control. Growth is likely to be 7.4% or less this year (down from 12% in 2010), so the government is trying hard to reverse the trend.

It has engaged in stimulus programs and lowered interest rates to spur growth. While the government is pumping money into banks to increase lending to state-owned enterprises and local governments, bank regulators are concerned about non-performing loans and leverage. Excess liquidity is rising, especially in the under-regulated non-bank sector, but inflation remains low. A Japanese-style asset bubble may not be far away. Bubbles are hard to predict, partly because they can be hard to distinguish from what others view as “trends,” and partly because it is hard to tell when and where the first chinks in the dam will appear.

Total debt in China (largely undertaken by opaque state-owned enterprises and local and regional governments) now equals 250% of GDP, up from 130% in 2008. But, like Japan in 1989, China’s banking system is fragile. Non-performing loans are disguised, and under-reported. Relative to the rapid expansion in non-government loans outstanding, the banks report a very unlikely decline in bad debts.

A serious setback in Chinese stocks and real estate could, as it did in Japan, force the realisation of losses that could severely affect the 300 million mostly urban “middle class” that have mortgages and own stocks. According to a recent report in The Financial Times, 90% of Chinese households own at least one home, and 76% of the assets or urban householders are in real estate.

China has a sufficient pile of foreign exchange reserves and other resources to bail out its banking system if need be. Japan did too.

But if a series of financial shocks hit the middle class, it may be difficult for the government to retain the confidence of the people in the country’s economic prospects, particularly if exports remain tied to sluggish Western growth rates. If that confidence is lost, China’s superpower status and the longevity of the Party may be in doubt.

From: Financial News, Dec 8, 2014