China's Restructuring: Drawing Lessons from the Japanese bubble burst

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CHUA TERENCE's picture

At first glance, the Chinese economy seems to be rebounding. The official Chinese Purchasing Managers' Index (PMI) rose to 50.8 in May from April's 50.4, beating market consensus and hitting a five month high. First quarter 2014 earnings for the Chinese banks were also mostly in line or above Bloomberg consensus. Data from Bloomberg reveal that net profit of Chinese banks grew an average of 12% year on year driven by healthy loan growth. Chinese banks listed on the Hang Seng Index (HSI), Hong Kong's stock exchange also mostly rebounded. Concerns of a banking sector crisis in China appear to have faded into the abyss. Behind that benign outlook however, a more worryingly phenomenon exist, Chaori Solar's missed payment on part of a bond coupon on the 7th March 2014, China's first onshore default set off a wave of domino effect that saw Zhejiang Xingrun's collapse on the 17th in the same month. Fears of a contagion effect to the rest of the world was however, overshadowed by positive data from China, one pertinent question however remains, will China experience the same collapse Japan did in the late 1980s?

The rising Chinese dragon

Since China reformed and opened up their economy nearly three decades ago, China’s huge achievements in social and economic development have resulted in their rise on the global stage. China has in the last decade recorded strong double digit growth that has seen the nation achieve huge prosperity and accumulated trillions of US dollars in reserves. In 2010, China rose to become the second largest economy in the world; their Gross Domestic Product (GDP) in 2012 was US$8.2 trillion while the US was US$16.2 trillion. China’s factory and services sectors had their best showings in months in May as demand rebounded, fuelling optimism that Asia’s largest economy may be steadying after a weak start to the year.

Japan, the land of the rising sun

Like China, in the three decades following 1960, Japan focused on growing their economy, achieving double digit growth in the 1960s allowing for rapid economic growth, now widely referred to as the Japanese post-war economic miracle. Their success established and maintained them as the world's second largest economy from 1978 until 2010, when China replaced them.

The second half of the 1980s also saw unprecedented growth in Japan, marked by rising stock and real estate prices that saw such prices balloon to record levels in the early 1990's. That period of prosperity did not last however, and according to data compiled from Japan's Real Estate Institute, property prices collapsed more than 35% during a nine-year period from 1991. The collapse of the real estate market also saw the Nikkei Index and Banks Index correct by 40% and 65%, respectively.

China's eerie similarity to Japan in the 1980s

During the 1980s, buoyed by the booming economy, Japan's loan growth grew at a faster pace than GDP growth during the bubble era, similar to what is currently happening in China. Property, widely used as a form of collateral to back banks' lending did not present a problem as long as property prices continued to rise, which supported rising collateral value. This resulted in lending growth to continue despite already outpacing GDP growth. Similarly in China, a decade of rapid expansion has resulted in structural oversupply which has in turn placed heavy downward pressure on residential property prices; cities of unoccupied residential flats have resulted in the term “ghost towns” to be coined, raising fears of a property bubble burst similar to Japan.

In a bid to avoid a slowdown in their economy, the Japanese also prevented their currency from appreciating too quickly due to their heavy export reliance which saw the Bank of Japan (BOJ) intervening to prevent the appreciation of the Yen. The move however, exacerbated the asset price appreciation within Japan. Parallels can be drawn between the move made by the BOJ and the People's Bank of China (PBOC) today. In February this year, growing fears of a Chinese hard landing saw the PBOC stepping in to devalue their currency to the USD, shedding more than 3% until date. This move by the PBOC to revitalise the economy risk re-inflating the credit bubble and a massive economic bubble collapse down the road.

Another important lesson gleaned from the Japanese bubble is as academics have aptly pointed out, not just the lack of disclosure but the deliberate concealing of non-performing loans through different means that resulted in the shock in the economy to be greater than initially thought. In China, there is growing scepticism that their reported non-performing loans are more optimistic than they have reported. While there is no lack of different estimates of what the possible size of the bad loans might be, it is possible to argue at this point that estimates of the size of the bad loans are at best estimates and cannot be accurately ascertained at this point. The fact though, is that continued denial and delay will exacerbate the bubble which will continue to grow and the magnitude of the problem too big for policymakers to deal with in the short to medium term.

The Japanese asset bubble collapse brought about what is now known as The Lost Decade or the Lost 10 years. Like Japan, Chinese banks are under huge pressure to lend to support the GDP growth target of 7.5% set by the government despite already facing a rising loan-to-deposit ratio; a ratio used to gauge the loans the banks make with the total amount of deposits they have. A quick look at Bloomberg reveal that the top five bank lenders in China are already overstretched and have seen rising loan-to-deposit ratio over the last 3 years, raising fears that this could spark a catalyst for the Chinese bubble burst.

Will China face the same economic calamity as Japan?

While many have predicted an eventual Chinese asset bubble burst and a hard-landing for the economy, it is my view that the Chinese economy can likely avert the same economic calamity as Japan should they act decisively now and this can be achieved with strong political leadership from the Chinese government. The Chinese government have shown that they can act decisively to introduce easing measures should the property correction continue in order to maintain their GDP target. This includes cutting the required reserve ratio (RRR) of rural banks and launching an expansive list of clean energy projects that aims to lead an economic rebound in the country. Moving forward, the speed in which Chinese officials start rolling out financial deregulation measures will be key to determine whether China can avoid the costly Japanese experience.

Another crucial element is the vast foreign reserves that China holds, estimated to be around US$4 trillion which it can utilise to recapitalise their banks, and cushion the economy in the event of an asset bubble burst. Given the lessons gleaned from the Chinese from the Japanese and the US bubble burst, the Chinese government will likely introduce crucial economic reforms needed for an overall economic restructuring and drive growth. They will do well to act more decisively to avert a financial calamity in their economy.

Conclusion

Despite the many similarities that the Chinese economy today shares with the Japanese in the 1980-1990's, China can avert a potential collapse of their financial system and economy if it acts decisively to contain the asset bubbles inherent in the economy. Financial deregulation, which has been much talked about by Chinese officials have so far yielded no concrete measures that have been implemented so far. Moving forward, in spite of the measures that the Chinese government is likely to be putting in place, the entire deleveraging of the sector is likely to be a prolonged process that could stretch out over the next few years. Chinese banks will see slower loan growth and the Chinese economy, slower growth, but it will be necessary. The Chinese have a famous saying, “paper cannot cover fire". And unless the hard decisions are made now, the Chinese might find themselves dealing with a much bigger fire than they can deal with.

References: 

"China official PMI hits five-month high in May, boding well for Q2" - Reuters http://in.reuters.com/article/2014/06/02/china-economy-idINKBN0ED09I20140602

“Is China about to overtake US as the world’s largest economy?" -  BBC http://www.bbc.com/news/business-27216705

"China Defaults Sow Property Cash Crunch Concern: Distressed Debt" - Bloomberg http://www.bloomberg.com/news/2014-03-30/china-defaults-sow-property-cash-crunch-concern-distressed-debt.html

Nakamura, Toshihiro; 2002 "A Declining Technocratic Regime - Bureaucracy, Political Parties and Interest Groups in Japan, 1950 - 2000" - http://www.unrisd.org/80256B3C005BCCF9/%28httpAuxPages%29/4AD5AF4732C0807FC1256C980035AA30/$file/nakamura.pdf