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China's economic struggles and the lessons of the 'three Japans'

Is China turning Japanese? Official attempts to prop up the Chinese stock market and the recent run of poor economic data have had commentators grasping for precedents from the Japanese experience. The problem is that China's dizzying ascent has been so fast, complex and uneven that no single comparison can do it justice. Today's China resembles a blurry overlay of at least three different phases of Japan's historical trajectory, each of which contains its own set of challenges for the rest of the world.

     The most topical parallel is with the bursting of Japan's bubble economy in 1990 and the deflationary aftermath. Rather than tackle the root causes, the Japanese authorities engaged in several rounds of "price-keeping operations" (so dubbed in imitation of the United Nations' peacekeeping operations) in which institutional investors were "encouraged" to support the stock market at critical levels. Needless to say, it did not work and probably helped to extend one of the longest bear markets in history.

     As is the case in contemporary China, the financial markets traditionally had minimal importance in Japan's bank and bureaucrat-driven economic system and the authorities considered them little more than a playground for speculators. They missed a crucial point. Vast and protracted inflation of financial asset prices inevitably has real-world consequences. Companies with bubbled-up stock prices are prone to engage in bubbled-up investment projects. As Japan slid further into its lost decades, nearly every industry found itself with too much debt, too many employees and too much capacity.

     China has a much higher natural growth rate than 1990s Japan, but there is evidence of increasing deflationary pressures, particularly in producer prices which are falling at 5%. According to the Financial Times' John Plender, "China is at the end of the wasteful debt-fueled investment boom that created ghost towns and imposed more spare capacity on already loss-making industries." Ultimately, Japan was sunk not by the stock market, but by the collapse in real estate prices, which created two banking crises within five years. It will be the fate of Chinese real estate that decides how closely China follows Japan's dismal record.

     In a worst-case scenario, the endgame would likely be a Chinese version of Abenomics -- Prime Minister Shinzo Abe's plan to reflate the Japanese economy -- including a substantial devaluation of the yuan.

China the competitor

The second parallel is with the Japan of several decades earlier. In the 1960s urbanization and heavy investment in industrial infrastructure powered a sustained period of double-digit gross domestic product growth known as the Japanese economic miracle. The "Lewis Turning Point" (named after the economist W. Arthur Lewis), when the flow of labor from the countryside to the cities started to tail off, was reached in the early 1970s, a quarter of a century after Japan's "Year Zero" in 1945. It was the increasing pressure on wages that marked the end of the long investment boom.

     Differences of definition make "apples-to-apples" comparisons impossible, but Japan's urbanization ratio rose from 38% in 1940 to 70% in 1970 -- an increase of 32%. If we take 1990 as China's "Year Zero," the urbanization ratio rose by a similar 36% -- from 20% to 56% -- over the subsequent 25 years. Likewise, even allowing for statistical leakage, it is clear that the proportion of investment to GDP in China today is well in excess of anything seen in Japan's high-growth phase; the multiplier effects of a slowdown must therefore be all the greater.

     The good news is that the impact of a slowdown on Japan was far from fatal. Yes, the natural growth rate halved, corporate profit margins crunched and the transition to a consumption-driven economy proved a tricky business -- it is only nearing completion now, 40 years on. Even so, compared with other developed countries Japan enjoyed strong growth through the 1970s and 1980s, and Japanese companies became dominant in a variety of knowledge-intensive sectors.

     If China follows this template, the result will be a ferocious global competitor in overseas markets for sophisticated products and brands while its own domestic market becomes increasingly unprofitable for foreign entrants.

China the disruptor

Most disturbing of all is the parallel with the third Japan, the grievance-driven challenger to the existing international order of 80 years ago. In a recent Nikkei Asian Review column, commentator Daniel Twining noted some intriguing commonalities -- the determination to achieve regional hegemony, the alliance with a European strongman (Japan with Nazi Germany, China with Vladimir Putin's Russia) and the aggressive push into Southeast Asian seas to secure resources. There is even the maintenance of a nearby puppet regime, with Kim Jong Un's North Korea standing in for "Last Emperor" Pu Yi's Manchukuo. Times have changed, of course, and outright colonialism is no longer on the menu. In today's world threats, blandishments and displays of economic and military muscle are the preferred option.

     The other eerie similarity is with the macroeconomic backdrop. In his thoughtful and generally underrated speech to mark the 70th anniversary of the end of World War II, Abe made explicit reference to the deflationary conditions that aided the rise of the militarists. Mark Metzler of the University of Texas makes the point in his study of the gold standard in prewar Japan. "It was the active excesses of liberal deflationism that undermined political liberalism in many of the places where it was weakest and most tentative ... social turmoil and right-wing terror incidents were one consequence ... ."

     With the exception of the eurozone's fringes, the world has avoided economic meltdown, but global trade volumes are declining for the first time since the financial crisis of 2008 and many emerging economies have been quietly sliding into crisis. Meanwhile, China -- like Japan in the early 1930s -- has been following a hard money policy for reasons of national prestige. Back then, Japan felt that returning to the gold standard was vital to being taken seriously as an imperial power. Today, China has allowed its currency to appreciate dramatically in real trade-weighted terms because it wants the yuan to be included in the basket of currencies that make up the International Monetary Fund's Special Drawing Rights. This would be the first step toward becoming the anchor currency of the region and, one day, challenging the primacy of the dollar.

     In benign economic conditions, this is a smart strategy. In a coordinated global downturn, it would exacerbate the economic pain -- with potentially dire consequences for China itself, the region and the world.

     It is reassuring to think that the decisions of policymakers -- whether central bankers or the top echelons of the Chinese Communist Party -- drive economic events, but in reality it is often the other way around. Economic events drive the decisions of policymakers, who can see no further ahead than the rest of us. It will be unpredictable macroeconomic developments that determine which of the "three Japans" provides the template for China in its next phase.

Peter Tasker is an analyst at Tokyo-based Arcus Research.

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