Will China Follow Japan into a Lost Decade of Growth?

For the Land of the Rising Sun, the economic miracle of the 1960s – 80s faded into the ‘lost decade’ of the 90s. At the current juncture, per-capita GDP in China is at a level similar to the mid-to-late 1970s in Japan, which was then at the height of its resurgence.

Rising Debt

For many, the path of credit growth is the biggest issue for China. Total social financing, a measure of credit that includes bank loans, the shadow banking sector and the domestic bond market, is around 260% of GDP in China today, compared to about 140% back in 2008.

It appears that there is a big contradiction in overall Chinese policy at work here – is the main aim to keep GDP growth at the same rate as the recent past as the credit boom implies, or is it to concentrate on the sustainability of growth and undertake much needed structural reform as policy statements insist?

If it is indeed the more significant latter, it would be reasonable to suggest credit growth will be tempered in time; it is simply not sustainable to continue at the current trajectory for many years to come without a nasty ending.

In Japan, debt to GDP is higher than in China, at over 400%, but there is a fundamentally important difference. The lion’s share of the Japanese debt pile is public borrowing, so is controlled by the Bank of Japan which, has infinite money printing power, in theory.

In China, it is corporates that hold more of the debt and the lenders are listed profit seeking banks. Many have rising levels of non-performing loans as fragile loans come under stress, and their ability to fund ongoing obligations via deposits certainly isn’t infinite. As such, they are likely to need recapitalisation down the line, so equity issuance or government bailouts in the form of debt for equity swaps seem increasingly inevitable. We are seeing signs of this already as some Chinese banks funnel debt towards sister asset management companies.

In itself, the total amount of debt means very little unless you consider how well-funded the debt is. The funding side of the balance sheet looks reasonable in China. The gap between the asset side and the deposit side of the system isn’t at crisis levels, with around $1.10 private sector credit per $1 of deposits in China.

But it cannot keep widening as it has been. Perhaps a real crisis point might occur if the endless ramping up of the volume and complexity of bank assets relative to the supply of funding were allowed to combine for the next five years or so. We suspect it won’t.

Stepping away from the Japan-specific comparison for a moment, we can also look at the role that foreigners might play in a liquidity squeeze. The capital account in China is relatively closed, i.e. foreigners play such a small role in funding Chinese banks that a withdrawal of foreign funding cannot trigger a meltdown. China is still a net lender overseas. It is interesting that in the best known examples of emerging markets crises in the past 20 years, it was the build-up of foreign liabilities in the financial system that eventually led to a collapse.

Government and Corporates

There are broad parallels that can be drawn between Chinese state-owned enterprises and the Keiretsu in corporate Japan; mired in red tape and unable operate freely, but neither can be be transformed properly either.

Part of the rationale for listing many Chinese state owned enterprises was to bring in more rational external shareholders. But, while the government retains control, most of these enterprises are politically-motivated policy instruments, rather than economically-motivated growth businesses.

It is important to beware of generalisation, but being publicly listed requires them to fund themselves at a private sector cost of capital, yet operate with excess baggage such that they generate poor public sector-like returns. The public sector continues to suck up credit growth while failing to generate a decent return on it. As long as the SOE sector is inefficient, China and investors therein rely on the new economy for sustainable earnings growth.

The more that credit growth outpaces productivity growth, the trickier it becomes to avoid a bust, which is why productivity improvement will be crucial for China’s predicament. As this chart neatly shows, total factor productivity has been a major swing factor in the growth of the best and worst emerging economies over the past 25 years or so.

Perhaps the biggest reason to suggest China won’t ‘do a Japan’, or the key differentiator in China’s favour, is that it has a potential growth rate – due to its current stage of development and trajectory – that is much higher than Japan’s was when it hit its debt wall.

Maybe China’s real issue is not whether it will face a Japan-like bust or a financial crisis, rather whether it will successfully bridge the middle income trap. Chinese businesses such as Tencent and Alibaba, the likes of which China hasn’t seen in its state-dominated past, give us good insight here.

Unlike when Japan was at a similar stage of development, we can see that the new economy in China is developing with such dynamism and entrepreneurial drive that it is successfully moving from wage cost arbitrage and infrastructure build out towards genuinely innovative, service-orientated growth. This will provide the next leg of the country’s evolution and leaves us with great optimism as active investors.

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