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Chinese economics with Japanese characteristics

Beijing needs a weaker yuan to ease deleveraging just when Trump is holding it hostage

Zhou Xiaochuan, former governor of PBOC, warns that China risks following Japan with an asset bubble burst.   © Reuters

One sign of the seriousness of the economic debate raging in China is that Zhou Xiaochuan is drawing parallels with Japan.

After 15 years at the helm of the People's Bank of China, the country's former top economic reformer, who stepped down in March 2018, is finally free to speak his mind.

Zhou did just that in London on March 11, warning that China risks following Japan with an asset bubble burst, an explosion of bad debt and years of economic stagnation.

It is was hardly what President Xi Jinping wanted as the showcase annual National People's Congress was drawing to a close in Beijing. Somebody pointing out the weaknesses in the economy just as he was trying to project strength.

The Communist Party spin machine is at pains to absolve Xi of culpability for the slow down in China, the debt mountain or the squeeze on private businesses. At the NPC, Yi Gang, Zhou's successor, demonstratively took the blame for a "credit crunch" that is driving companies into collapse.

But, far from Beijing, Zhou could speak his mind. Focusing not on sparing the boss's blushes but on China's future, he wondered where the country would be in 2029.

And, quite rightly, instead of gazing into a crystal ball, he looked at Japan's miserable economic performance of the past twenty years.

"Japan had very fast development and later then a so-called lost decade," Zhou said at London's Chatham House. "The Chinese economy may have a similar over-leveraged problem, and we need to absorb the knowledge and lessons from what happened."

The parallels are jarring. Corporate bond defaults are at a record high, banks' non-performing loan ratios reached a 10-year high and gross domestic product just expanded at its slowest pace since 1990, 6.6% in 2018. China's population is aging rapidly, a dynamic more conducive to deflation than stable prices.

Moreover, China, like Japan in the 1980s, is an economy expanding its role in the world. Its exporters are making inroads into the U.S., while corporate America struggles to crack the Chinese market. The result is a bilateral trade deficit fueling bitter disputes. Sound familiar?

Zhou's turning-Japanese fears may only intensify as Donald Trump opens another front in his trade war with Beijing: currencies.

The U.S. president makes no secret that he believes the U.S. dollar is prohibitively strong. He wants Beijing to agree to a no-manipulation clause.

Trump's ultimate goal is a second Plaza Accord of sorts. The first one was forged in 1985 in a fabled New York hotel that Trump would later own. That pact to drive the yen higher still stands as one of Tokyo's biggest policy blunders, because it paved the way to the bubble and subsequent deflation.

Japan's Finance Minister Noboru Takeshita, right, U.S. Treasury Secretary James Baker, center, and representatives of other major countries meet on Sept. 22 1985 in New York to discuss international economic policy.   © AP

The deal made Japan's then-Finance Minister Noboru Takeshita a global figure. The yen's 50% surge versus the dollar from 1985 to 1987 enhanced Tokyo's status as a financial center. But by the time Takeshita rose to the premiership in November 1987, regret coursed through the government. The strong yen was straining Japan's export engine and boosting asset bubbles.

Tokyo is still working through the fallout. Epic stimulus since then left Japan with the largest debt burden among developed nations, $10 trillion at present, or 238% of GDP.

Two decades of zero interest rates failed to restore healthy price dynamics. At the end of 2018, the Bank of Japan's balance sheet was larger than the entire $4.9 trillion annual GDP. Even so, inflation is barely halfway to the 2% target.

This is not necessarily China's future. The lesson, however, is not to outsource currency policy for short-term tactical gain. For Xi's team, that gain would be persuading Trump not to add new tariffs on top of those already imposed on roughly $250 billion of mainland goods. Getting Trump to disarm would make it easier for Xi's team to keep growth above 6% and stifle domestic discontent.

Unfortunately, Trump is effectively holding the yuan hostage. And at the worst moment for Asia's biggest economy. If there were ever a time to use the exchange rate as a pressure valve, it is now. But Trump wants a stronger yuan just when a weaker one might help Beijing maintain growth.

The yuan 6.5% gain versus the dollar over the last 12 months is about geopolitics, not economic logic. It is another Trump-driven blow that is undermining China's contribution to global demand. In February alone, mainland car sales dropped 13.8% year-on-year. Bad news for all carmakers, including Detroit's.

There are many lessons Tokyo can teach Beijing. One is to own up to your debt troubles and tackle them expeditiously. Had Prime Minister Shinzo Abe's party done that in the 1990s, Japan might not have lost those decades.

Zhou is under no illusions. In London, he lamented the runaway credit that is undermining global confidence in China. "So we need to have a good disposal procedure to dispose of those failed companies," he said. "But meanwhile we still need to emphasize how to improve the Chinese private sector as a major engine of the economy."

Call it creative destruction, with Chinese characteristics. During his 2002-2018 tenure at PBOC, Zhou was never a radical. But he is a disciple of former Premier Zhu Rongji, who shook up state-owned enterprises in the late 1990s. It was Zhou, for example, who lobbied Beijing to include the yuan in the International Monetary Fund's top-five currency club in 2016. The idea was to force Xi's party to modernize the financial system and let markets price the yuan.

Yet the yuan is obliged to trade in Trump-adjusted terms. Given China's vulnerabilities and $34 trillion pile of public and corporate debt, the yuan's jump these last 12 months is irrational. It falls to Zhou's successor to reconcile the gap between realpolitik and financial realities.

Yi's apology affords President Xi some cover as he faces growing questions about whether the recent stimulus can counter Trumpian headwinds. Industrial output hit a 17-year low in February, down 5.3% from January, as exports sputter. Outbound shipments plunged 21% in February from a year earlier.

A weaker yuan would help. Not a devaluation that provokes Trump or panics markets, but a gradual retreat from an artificially-high exchange rate. Anything to provide breathing room to deleverage. And avoid the deep hole from which Tokyo is still struggling to emerge.

William Pesek is an award-winning Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades." He was given the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia for his Nikkei Asian Review work.

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