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Japan's four lessons for debt addict China

Beijing must clamp down on credit and pounce on shadow banking to avert a crisis

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Credit bubbles and real estate debt all sound very familiar.   © Reuters

Moody's certainly knows how to change the subject. In the 26 days since it downgraded China, the first cut since 1989, the market sentiment pendulum has swung from boom to bust.

It was not as controversial as Standard & Poor's slashing Washington's credit rating in 2011. But Moody's sent Beijing into full-rant mode, with the Finance Ministry calling the downgrade "absolutely groundless" and state media claiming it "underestimated the country's resolve to restructure its economy." Beijing's response was itself troubling, smacking as much of denial as of historical amnesia. The history in question is Japan's.

The China-is-turning-Japanese debate has returned with a unique ferocity since Moody's pounced, and it feels eerily familiar. Researchers buzzing about "zombie companies," bubbles in credit, debt and real estate and chronic overcapacity confront a great wall of true believers arguing 'don't panic'.

China is unstoppable, bulls say. It is the New Economy, it is run by geniuses, its potential is boundless and anyone who cannot see that is either a cynic or a fool -- or both.

Familiar, because the same was said of Japan 28 years ago. Any economist who said in 1989 that Japan had reached its "Minsky moment", when a debt-fueled speculative bubble collapses, might be out of a job. A year later, the reckoning was unmistakable. Is the Chinese pendulum swinging negative for valid, fundamental reasons? U.S. traders last week increased short positions on Chinese exchange-traded funds to the $6 billion mark, the highest since 2015, back when Shanghai stocks were in freefall. Kyle Bass of Dallas-based Hayman Capital, who shorted Japan in recent years, now has China in his sights. Asia's biggest economy is "beginning to unravel", Bass warns.

One question we can answer is what China must learn from the lost decades Japan is still trying to escape from. Here are four:

Own theProblem. The list of similar reference points between 1980s Japan and today's China is growing: the role of runaway stimulus in fueling gross domestic product and assets; the level of corporate debt-to-GDP ratios; surging bad loans; the central role of real estate as collateral across sectors; explosions in local government debt; Chinese tycoon Liu Yiqian spending $170 million on a Modigliani; China`s CC Land Holdings paying $1.4 billion for a London building; and intensifying spin from Communist Party apparatchiks that there's nothing to worry about here.

Yet the first step towards addressing a problem is admitting you have one. Beijing should have done that in 2014, when corporate debt topped that of the U.S. ($14.2 trillion at the time). It should have accepted reality in mid-2015, when chaos in Shanghai shares was spreading the globe. Instead, it churned out ever more stimulus. It is time China looked in the mirror, because its face-saving public relations push is no longer working. Its excesses are now spilling into the global economy in ways Japan's never did. Bitcoin bubble, anyone?

Be Quick and Bold. Nearly three decades after its bubble burst, Japan is still grappling with deflation, stagnant wages and waning market share. It is the result of a succession of governments (18 since 1989) acting too timidly to strengthen Japan's balance sheet, including today's premier Shinzo Abe. Junichiro Koizumi (2001-2006) gets the most credit for clearing up the 1980s mess; on his watch, bankers finally began writing down upwards of $1 trillion of bad loans. But it was too little, too late and deflation deepened anyway.

Immediately, Beijing must do three things on which Tokyo dragged its feet. First, clamp down hard on credit growth and demand that banks make an honest and public accounting of their riskiest liabilities. Second, pounce on a shadow banking system feeding uncompetitive state-owned companies with loans they can never replay. Third, create a mechanism to dispose of distressed assets, perhaps modeled after America's Resolution Trust Corp. from the 1980s. Only bold action will move China from treating the symptoms of its dysfunction to addressing the underlying causes. Given a debt-to-GDP ratio of 261% and growing, China is not there yet.

Watch the Currency. Beijing has shown greater tolerance for a stronger yuan this year than most investors thought possible. Try as China may to deny it, Donald Trump's fingerprints are all over this ploy. For President Xi Jinping, some export losses are preferable to the U.S. president imposing 45% import tariffs or changing the "one China" policy toward Taiwan. One of Tokyo's biggest blunders, though, was agreeing to the 1985 Plaza Accord, a bad bargain struck at the New York hotel Trump would later own. It strengthened the yen sharply versus the dollar, making New York's Rockefeller Center cheaper for Japanese companies. It suddenly was easier to make terrible bets on golf courses in California and Hawaii and overpay for every Picasso, Renoir and Van Gogh on auction. A stronger yuan encourages China Inc. to make vanity purchases and indulge a dangerous overreach, mimicking steps Japanese peers wish they had never taken.

Indulge in Shock Doctrine. Milton Friedman and fellow free-marketeers argued one should never let a crisis go to waste. When chaos and fear reign, technocrats can seize the opportunity to carry out some shock therapy. Japan erred by not exploiting moments of turmoil to restructure its corporate system, shake up a bureaucracy geared more for 1989 than 2017 or engineer a true financial big bang.

Xi should use today's bust-speculation to accelerate the private sector's ascent. The dominance of state-owned enterprises and banks produces daunting misallocations of resources, priorities and risk. Inefficient, opaque and environmentally unsound, state entities are at the core of so many of China's vulnerabilities. No effort to change China into a more innovative and services-driven economy can succeed without shocking the state system. It is time the world refocused attention on China's Japan-like time bomb. A bust in the No. 2 economy would make previous crises look cute by comparison.

William Pesek is a Tokyo-based journalist and author of "Japanization: what the world can learn from Japan`s lost decades". He is a former columnist for Bloomberg.

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