China’s Problem Isn’t Nancy Pelosi —It’s Turning Japanese

Xi Jinping has a growing list of things to worry about: Covid-19, crashing property values, inflation, Nancy Pelosi, you name it. But the Chinese president’s biggest problem might be in Tokyo.

Something strange is going on amongst Chinese banks: a whole lot of lending from institution to institution. Last Friday, bank-to-bank dealing in the overnight repurchase agreement market hit a record of more than $900 billion. This is what happens when you run out of productive things to do with the tidal waves of capital the central bank churns into the financial system.

It’s precisely the sort of “liquidity trap” about which John Maynard Keynes warned decades ago. It’s how credit-creation mechanisms freeze up. Students of Japan’s 2000s know the drill. They also know this is very much not where Xi wanted the People’s Bank of China—or his economy—to be in 2022.

As economist Ming Ming at Citic Securities tells Bloomberg, “excess cash is piling up in the financial system instead of being funneled to the real economy.” Despite so much PBOC-created cash sloshing around, China’s banks are resorting to the financial equivalent of talk amongst themselves.

For years now, economists like Nobel laureate Paul Krugman worried China might fall into a Japan-like funk. That was after the 2008 Lehman Brothers crisis, when the globe followed the Bank of Japan down the quantitative easing path.

The details of China’s quandary are different than what the Krugman’s of the world expected. Descending into deflation doesn’t seem to be Beijing’s challenge. Not with Russia’s Ukraine war sending prices of oil and other commodities skyward.

Yet the “pushing on a string” problem China faces is arguably the last thing Xi needs as growth flatlines at the worst possible moment given his political objectives.

Later this year, Xi plans to fulfill his longtime dream: securing a norm-breaking third term as Communist Party leader. Odds are high that will still happen, yet Xi’s self-imposed economic troubles risk spoiling the party.

A major reason China faces recession chatter is his “zero Covid” policy and the massive lockdowns it requires. Draconian shutdowns of entire metropolises worked in 2020. It’s futile, though, amid more transmissible variants. Today, containment is virtually impossible, even if Xi missed the memo.

Several times since January, Beijing signaled a pivot to a nimbler “dynamic zero Covid” strategy, whatever that means. Yet investors still expect lockdowns to be Beijing’s default reaction to new infection waves.

Lu Ting, economist at Nomura Holdings, thinks China is now trapped in a “Covid business cycle.” The risk is that China’s GDP will gyrate indefinitely with spikes and plunges in infection rates.

It’s high time Xi recalibrated China’s Covid response. The priority should be better vaccines and mass testing. Doing so might get China closer to this year’s 5.5% GDP target. It almost might slow the worst capital flight China has experienced since 2014.

Xi can no longer rely on the PBOC to save the day. Nor can his government safely open the fiscal floodgates given Beijing’s crushing debt load. In the first quarter alone, China’s gross debt rose $2.5 trillion, far outpacing Washington’s $1.5 trillion increase, according to the Institute of International Finance.

Hence the logic behind Xi recalibrating his Covid policy in place of conventional stimulus. Granted, Xi has a lot on his plate at the moment, including House Speaker Pelosi’s Taiwan visit. Frankly, it’s drawn an over-the-top reaction from a Chinese government you’d think has bigger challenges on its mind than ordering up military drills.

Economist Michael Pettis at Peking University says China should be studying the lessons from Japan’s lost decades—and heeding them.

“The reason for comparing China today with Japan is that they both had, among other things, serious income imbalances, years of non-productive investment, heavily administered banks underpinned by government guarantees, vastly overvalued real restate and soaring debt,” Pettis says.

These imbalances led to the bubble troubles with which Japan is still grappling decades later. Japan, Pettis says, faced a “difficult adjustment after a forty-year investment-driven growth miracle. These were also the same conditions in every other country that followed a similar growth path, and they all had brutally difficult adjustments.”

This includes China. The PBOC losing monetary traction, like the BOJ decades before it, is an ominous sign.

The bottom line: if Beijing wants to avoid Japan’s fate, Pettis says, “it must understand what actually caused it and why it is so difficult to rebalance income, and it must take specific steps Tokyo didn’t or couldn’t. Otherwise pretending it can’t happen in China almost guarantees that it will.”