How can China’s economy end up like Japan’s?

debt

Why are we worried it may turn into another Japan?
Factors such as high debt-to-GDP ratio, the speed at which it built up, an enormous amount of government money spent on propping up the stock market ($200 billion), bad loans, financial frauds, and capital outflow are all engendering a concern for a financial crisis. There are many reasons why we may not be in for a crisis (explained here), but if not crisis, the real concern is that China’s economy may end up like that of Japan.

What happened in Japan?
In the 1990s, banks in Japan liberally lent to real estate projects based on wildly speculative land values. At one point, a park in Tokyo was meant to have the same value as an entire state in the U.S. (or something like that). Then the bubble burst in 1991 with land and stock prices spiralling down. However, banks did not call in bad loans and kept them on the books as if nothing was wrong (on the orders of the banking regulator), and the central bank pumped Japanese banks with liquidity. That prevented the financial system from a comprehensive collapse. But there was nothing to do about the bad debts, which in turn limited banks’ ability to make new loans to worthy businesses. Corporations on their part spent all the little profit they made paying down debt rather than investing in new projects (that is usually how an economy grows). So the economy was literally stagnant.

How bad is China’s situation?
So notwithstanding a financial crisis, we are concerned that China might indeed face a similar fate. But it’s worth noting that they narrowly avoided a lost decade in 1997 by transferring bad loans to asset management companies, and funnelling liquidity into banks from the Treasury. Then, unproductive SOEs were ruthlessly shut down (what the premier Zhu Rongji is known for, and the current premier Li Keqiang is being compared to) and people were allowed own and sell houses (this is when the People get the sweet taste of capitalism for the first time since 1945). The economy took off, and so corporations made enough to pay down all the debt.

Of course, the situation now is different: growth rates are expected to dither and fall below 6%. And although the quality of lending is better, it is huge in absolute terms: 260% by some estimates, which in itself is not that bad since i) US and Japan have a higher ratio ii)has enough income and assets to pay down. But still it’s concerning. The way to reduce debt-to-GDP ratio is obviously to reduce credit, but that comes at the expense of growth. For political reasons, the CCP cannot afford to slow growth and if you slow growth then people are not able to pay back their debt.

Much of the information here was taken from Arthur Kroeber’s China’s Economy: What Everyone Needs to Know

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