China’s economy is looking at a new wave of Japanification

The next few months put Japan in line for a series of anniversaries it would probably prefer to forget. But these are dates which the leadership in China may be wise to mark: the detonation of timebombs with counters set ticking by a property bubble.

For these are, some would argue, distinctly echoey times. New research suggests that, if it is not careful, China may be on track for a new wave of Japanification.

Back in 2003, Japan could no longer fool itself that all was well. The 1990s had pitched the country off a trajectory on which it once seemed capable of overtaking the US. Its subsequent mishandling of the bad loan mountain built during its 1980s vainglory days put paid to the notion that the country could easily recover.

Vast banking mergers, encouraged by Tokyo over the previous three years, were not enough to disguise a collection of interlocking and unresolved crises. In March 2003, Sumitomo Mitsui Financial Group conducted a panicky reverse merger with a subsidiary amid huge losses. In April, the first signs began to emerge that one of the country’s largest lenders, Resona, was flailing. By May, taxpayers had rescued it with a $17bn nationalisation programme. Later that year and with the emergency klaxons sounding, a once top-tier regional lender, Ashikaga, went bankrupt. All of these events were deferred explosions which might have done far less damage, had they gone off earlier.

The problem, as a team of Citigroup analysts declared last week, is that China today looks “strikingly similar” to Japan in its post property bubble era. The countries’ respective demographic profiles, with China’s population now shrinking as Japan’s did years earlier, provide a reminder that after 1990, Japan’s housing price index fell as the 35- to 54-year-old cohort decreased. The report focuses its warnings on the potential risks for China’s banking system.

Citigroup identifies several areas of similarity. Both countries entered extended phases of strong GDP growth (Japan’s began in the postwar era and China’s after joining the World Trade Organization in 2001) via investment in infrastructure and the encouragement of exports. Between 2010 and 2020, capital formation represented an average 43 per cent of Chinese GDP growth, according to the World Bank. When its bubble burst in 1990, Japan’s capital formation proportion was at roughly 36 per cent, and considered very high.

Japan and China also financed their growth in a similar way. Japan’s bubble era was fuelled by indirect financing provided by commercial banks, which were nudged by the authorities into funnelling soft loans towards favoured industrial sectors. Similarly, says Citigroup, China has developed a financial system mainly dependent on indirect financing. As well as the tools available to the People’s Bank of China, the government can direct the lending activities of commercial banks via a series of mechanisms.

Japan’s 1987-89 property and stock bubble expanded most rapidly after the authorities introduced easing policies to promote domestic demand. Borrowing expanded dramatically and liquidity was funnelled into stock and property until the point where, for companies, financial speculation became more profitable than actually running a business.

China, decades later, has also allowed the real economy and the financial system to decouple. The country’s clearly bubbly property market, Citi estimates, hit $65tn by 2020, exceeding that of the US, EU and Japan combined. By 2021, 41 per cent of the total assets in China’s banking system were accounted for by property-related loans and credit. The run-up to the property bubbles of both countries was accelerated by the existence of a vast shadow banking market, which evolved to bypass state-imposed lending limits and other restrictions.

Citi analysts even see a parallel between the two nations’ relationships with the US. As Japan’s trade surplus ballooned, competitive friction with America escalated to an outright trade war in the 1980s, with technology, intellectual property and security concerns at its heart. There are parallels in the way that, for example, recent legislation and other measures in the US have sought to restrict non-American access to advanced technology.

These similarities may not be exact equivalents, but their overall effect could be. Twenty years ago, Japan was only just getting to the bottom of its post-bubble slump. Zombie company debt colonised the balance sheets of strained financial institutions, corporates and households were in a phase of long-term deleveraging and interest rates were kept low. This is Japanisation with Chinese characteristics, concludes Citi — and the risks investors should heed are those in the banking system.

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