Satyajit Das: The World Turns Japanese
A review of the similarities -- and differences -- between the collapse of Japan's bubble economy and the post-global financial crisis economies of developed nations.
Despite a history of conflict and competition, China and Japan share a contiguous geography and development models. China may also share Japan’s economic fate.
Japan’s post-war economic recovery and China’s more recent growth was based on an export-driven model, using low-cost labor to drive manufacturing. Both countries used undervalued currencies to provide exporters with a competitive advantage. Exports were promoted at the expense of household income and consumption. Both encouraged high domestic savings rates, which were used to finance investment. Both countries generated large trade surpluses, which were invested overseas, primarily in US government securities, to avoid upward pressure on their currencies and to help finance purchases of their exports. Both also used high levels of investment financed domestically to drive economic growth.
The Plaza Accord, signed on September 22, 1985, forced Japan to revalue its currency due to the appreciation of the yen, reducing Japanese exports and economic growth. In order to restore growth, policymakers engineered a credit-driven investment boom to offset the effects of a stronger yen, driving a bubble in asset prices that collapsed. Government spending and low interest rates have been used to avoid a collapse in activity exacerbating imbalances. This has resulted in large budget deficits, very high levels of government debt, and enlargement of the central bank balance sheet, in part to finance the government and support financial asset prices.
China’s resistance to a sudden, sharp revaluation of the Renminbi is based on avoiding the Japanese experience. China’s response to the global financial crisis, which triggered a large fall in Chinese exports and a slowdown in economic activity, is similar to that of Japan following the Plaza Accord. Recent Chinese growth has been driven by a rapid expansion of credit that has driven an investment boom.
Becoming Poor Before Getting Rich
As with the global economy, there are many points of correlation and divergence between the positions of Japan in the early 1990s and China today.
Investment levels are high, in similar areas like real estate and infrastructure. Chinese fixed investment at around 50% of gross domestic product (GDP) is higher than Japan’s peak by around 10% and well above that for most developed countries of around 20%.
Like Japan before it, China’s banking system is vulnerable. Rather than budget deficits, China has used directed bank lending to specially targeted projects to maintain high levels of growth.
The reliance on overvalued assets as collateral, and infrastructure projects with insufficient cash flows to service the debt, means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a significant portion of China's large pool of savings and income, reducing the economy’s growth potential.
At the onset of its crisis, Japan was a much richer country than China, providing it with a significant advantage in dealing with the slowdown. Japan also possessed a reputable education system, strong innovation, technology, and a stoic work ethic that helped with adjustment. Japan’s world-class manufacturing skills and significant intellectual property in electronics and heavy industry made it less reliant on cheap labor, allowing the nation to defer but not entirely avoid the problems.
In contrast, China relies on cheap labor to assemble or manufacture products for export using imported materials. The shortage in availability of labor and rising wages are increasingly reducing competitiveness. China’s attempts at innovation and high technology manufacturing are still nascent.
Chinese authorities admit that the credit-driven investment strategy in response to the global financial crisis increased domestic imbalances and resulted in misallocation of capital, unproductive investments, and loan losses at government-owned banks. China faces significant challenges in shifting away from its investment-led growth model. Growth based on endless subsidized expansion of capacity is increasingly not viable. Attempts to continue the present strategy or a failure to adjust may cause an economic slowdown, greater than forecast with consequences for China’s social and political stability.
In recent years, popular awe at the achievements of China has increased. But it is entirely possible that China’s spectacular success could end in surprising failure if the country fails to make the needed economic transition. The question now: Can China avoid “turning Japanese?”
Until 1990, Japan was highly successful, growing strongly with only brief interruptions. Since 1990, after the bubble economy burst, Japan has been mired in almost two decades of uninterrupted stagnation.
The Japanese experience suggests that the state can provide palliative care to an economy in crisis but may have limited ability to restore economic health. The real lesson from Japan is that the only safe option to prevent a prolonged period of stagnation is to avoid a debt-fuelled bubble and subsequent build-up of public debt in the first place. But then again... it is too late for that!
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