“Since the Chinese housing bubble burst,” said Richard Koo of the Nomura Research Institute in a recent lecture, “I’ve been getting countless calls from Chinese journalists, economists, investors and sometimes policy makers asking me, ‘Are we going to take the next step? way of Japan?’”
Mr. Koo is a good person to ask: he has devoted his career to studying the aftermath of financial excesses. When the US economy’s recovery from the first Gulf War faltered in 1991, his then boss at the New York Federal Reserve, Edward Frydl, became concerned about an overload of debt and commercial real estate. This fueled “a widespread financial and economic conservatism among companies and consumers,” Frydl argued. Demand for credit was subdued as companies “focused their efforts on balance sheet restructuring.” To describe these tensions, he coined the term ‘balance sheet recession’.
Mr. Koo later realized that Japan suffered from the same overhangs, but much worse. After the stock market bubble burst in 1989, stock prices fell 60% in less than three years. Real estate prices in Tokyo have been falling for more than a decade. By some measures, deflation continued even longer. Even the price of golf memberships – traded on organized exchanges in Japan – fell by 94%. Many companies, which had borrowed to buy property or shares of other companies, found themselves technically insolvent, with assets worth less than liabilities. But they remained liquid and earned enough income to meet current obligations. With survival at stake, they shifted their efforts from maximizing profits to minimizing debt, as Mr. Koo put it.
In a healthy economy, companies use money from households and other savers and invest the money in growing their business. Things looked different in post-bubble Japan. Instead of raising funds, the business community began to repay debts and build up its own financial claims. The traditional financial deficit turned into a chronic financial surplus. The inhibition of business deprived the economy of much-needed demand and entrepreneurial power, condemning it to a deflationary period of a decade or two.
Is China going the way of Japan? Chinese companies have accumulated even more debt, relative to the size of the country’s GDP, than Japan’s in its bubble era. House prices in China have started to fall, hurting the balance sheets of households and real estate companies. Credit growth has slowed sharply, despite interest rate cuts. And the financial flow statistics show that the financial deficit of Chinese companies has decreased in recent years. According to Mr Koo, China is already in a balance sheet recession. Add to that a declining population and a hostile America and it’s easy to be gloomy: Will things go the way of Japan? It should be so much luck.
But when you look closer, the case is less convincing. Much of the debt incurred by Chinese companies is owed to state-owned enterprises that will continue to borrow and spend, with the support of state-owned banks, as Chinese policymakers require. In private companies, debts are concentrated on the books of project developers. They are reducing their debts and cutting back on investments in new housing projects. But in the face of falling real estate prices and weak home sales, even developers with robust balance sheets would do the same.
The end of China’s real estate boom has made households less wealthy. This probably breeds conservatism in their spending. It is also true that households have been paying off their mortgages early in recent months, which has contributed to the sharp slowdown in credit growth. But studies show that household debt is low relative to their assets. Their mortgage prepayments are a rational response to changing interest rates and not a sign of balance sheet stress. When interest rates fall in China, households cannot easily refinance their mortgages at the lower interest rates. It is therefore logical that they pay off old, relatively expensive mortgages, even if that means paying off investments that now yield lower returns.
What about the change in corporate behavior reflected in China’s financial flow statistics, which show that the corporate sector is moving towards financial surplus? This contraction is largely driven by the crackdown on shadow banks, according to Xiaoqing Pi and her colleagues at Bank of America. When financial institutions are excluded, business still demands money from the rest of the economy. Chinese companies have not made the collectively self-defeating switch from maximizing profits to minimizing debt, condemning Japan to a deflationary decade.
Japanese lessons
These differences show that China is not yet in a recession comparable to Japan’s. And Mr Koo himself would like to emphasize one ‘major’ difference between the two countries. When Japan entered a balance sheet recession, no one in the country had a name for the problem or an idea of how to combat it. Today, he says, many Chinese economists study his ideas.
His recipe is simple. If households and businesses do not want to borrow and spend even at low interest rates, the government will have to do so. Budget deficits must offset private sector financial surpluses until their balance sheets are fully repaired. If Xi Jinping, China’s ruler, gets the right advice, he can solve the problem in 20 minutes, Koo said.
Unfortunately, Chinese officials have been slow to respond so far. The country’s budget deficit, broadly defined as various types of local government borrowing, has narrowed this year, exacerbating the downturn. The central government has room to borrow more, but seems reluctant to do so and prefers to keep the powder dry. This is a mistake. If the government spends too late, it will probably have to spend more. It is ironic that China is at risk of entering a prolonged recession, not because the private sector plans to clean up its finances, but because the central government is unwilling to make its own balance sheet dirty enough.
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From The Economist, published under license. Original content can be found at https://www.economist.com/finance-and-economics/2023/09/10/does-china-face-a-lost-decade
