“Since the Chinese real estate bubble burst,” Richard Koo of Nomura Research Institute noted in a recent talk, “I’ve received tons of calls from Chinese journalists, economists, investors, and sometimes policymakers asking, ‘Are we going to continue? the path of Japan?’”
Koo is the right person to ask: he has dedicated his career to studying the aftermath of financial excess. When the recovery of the American economy faltered in 1991 after the first Gulf War, his then boss at the New York Federal Reserve, Edward Frydl, began to worry about excess debt and commercial property. That dynamic “fueled a widespread financial and economic conservatism among companies and consumers,” Frydl maintained. Demand for credit was low, because companies “directed efforts toward restructuring balance sheets.” To describe those tensions, he coined the term “balance sheet recession.”
Koo later realized that Japan suffered from the same excesses, although much worse. After the stock market bubble burst in 1989, share prices plummeted 60% in less than three years. In Tokyo, real estate prices have fallen for more than a decade. Deflation, by some measures, persisted even longer. Even the price of golf passes (traded on exchanges organized in Japan) plummeted by 94%. Many companies, which had gone into debt to buy property or shares in other companies, found themselves in a situation of technical insolvency, with assets less valuable than liabilities. However, they continued to have liquidity, with sufficient income to meet ongoing obligations. With survival at stake, they refocused efforts from maximizing profits to minimizing debt, in Koo’s words.
In a healthy economy, companies use the funds contributed by families and other savers and invest them in the growth of their businesses. In post-bubble Japan, things took a different turn. Instead of raising funds, the business sector began to repay debts and accumulate financial rights of its own. Its traditional financial deficit became a chronic financial surplus. Corporate inhibition deprived the economy of much-needed demand and business vigor and condemned it to a decade or two of deflation.
Is China going the way of Japan? Chinese companies have accumulated more debt (relative to the size of the country’s GDP) than Japanese companies at the time of their bubble. House prices in China have begun to fall, damaging the balance sheets of households and real estate companies. Credit growth has slowed sharply, despite interest rate cuts. And fund flow statistics show a reduction in the financial deficit of Chinese companies in recent years. In Koo’s opinion, China is already in a balance sheet recession. Add to that a declining population and a hostile United States, and it’s not hard to be pessimistic: Will it go the way of Japan? I should have the same luck.
Now, on closer inspection, the case is less conclusive. Much of the debt incurred by Chinese corporations is owed to state-owned companies that will continue to borrow and spend, with the support of state-owned banks, if policymakers demand it. Among private companies, debt is concentrated on the books of real estate developers. These are reducing their liabilities and cutting investment in new real estate projects. The fact is that, in the face of falling real estate prices and weak home sales, even developers with solid balance sheets would be doing the same.
The end of China’s housing boom has made households less wealthy. Presumably this encourages conservatism in spending. It is also true that in recent months households have repaid mortgages early, which has contributed to the sharp slowdown in credit growth. However, studies show that household debts are low relative to their assets. Prepayment of mortgages constitutes a rational response to the evolution of interest rates, not a sign of stress on balance sheets. If Chinese interest rates fall, households cannot easily refinance mortgages at lower rates; Therefore, it makes sense to pay off old and relatively expensive mortgages, even if it means rescuing investments that now offer lower returns.
And what about the change in corporate behavior shown by China’s cash flow statistics, with the corporate sector moving into a financial surplus? The reduction is largely due to the crackdown on shadow banking, say Xiaoqing Pi and her colleagues at Bank of America. If financial institutions are excluded, the business sector continues to demand funds from the rest of the economy. Chinese companies have not made the collectively counterproductive shift from maximizing profits to minimizing debt, a shift that doomed Japan to a decade of deflation.
These differences show that China is not yet in a recession similar to that of Japan. And Koo insisted on highlighting the “enormous” difference that exists between the two countries. When Japan plunged into a balance sheet recession, no one in the country had a name for the problem or an idea of ??how to combat it. Today, he said, many Chinese economists study his ideas.
His recipe is simple. If households and companies don’t borrow and spend even when interest rates are low, the government has to do it instead. Fiscal deficits must offset the financial surpluses of the private sector until their balance sheets are completely healthy. If Xi Jinping, the Chinese ruler, receives proper advice, he can solve the problem in twenty minutes, Koo assured.
Unfortunately, Chinese officials have so far been slow to react. The country’s budget deficit, broadly defined to include various types of local government borrowing, has tightened this year, worsening the recession. The central government has room to borrow more, but seems reluctant to do so, preferring to conserve ammunition. This is a mistake. If the government spends late, it will likely have to spend more. It is paradoxical that China is at risk of falling into a prolonged recession, not because the private sector is determined to clean up its finances, but because the central government is not willing to sufficiently dirty its own balance sheet.
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Translation: Juan Gabriel López Guix
