Sift through Japanese history for a China forecast

China's imbalances today make it much like Japan in the late 1980s, and Tokyo provides one model for Beijing's debt and consumption rebalancing.

Japan in the late 1960s and early 1970s may share many developmental characteristics with China today, but the Japanese economy in that earlier period never achieved, as far as I can see, the kinds of imbalances that it did much later in the 1980s and so it is not really comparable to an extremely unbalanced China today.

These imbalances are well documented. The important characteristics of Japan in the late 1980s would almost certainly include the following:

– Japan in the late 1980s grew at extraordinary rates, fuelled by a credit-backed investment boom funded at artificially low interest rates.

– Although for many decades much of the investment may have been viable and necessary, by the 1980s investment was increasingly misallocated into expanding unnecessary manufacturing capacity, as well as fuelling surges in real estate development and excess spending on infrastructure.

– Artificially low rates, set nominally by the central bank but in reality by the Ministry of Finance, and coming mainly at the expense of household savers also fuelled a bubble in local assets.

– An artificially low currency fuelled very rapid growth in the tradeable goods sector while also constraining household income growth.

– Because the growth model constrained growth in household income and household consumption, it forced up the domestic savings rate to extraordinary levels.

– The combination of low consumption and excessive manufacturing capacity required a high trade surplus in order to balance production with demand.

– And finally, and most worryingly, debt levels across the economy began to soar as debt rose much faster than debt servicing capacity.

All of this is true of China today, and this is why it is much more important to understand how Japan rebalanced after 1990 if you want to understand the challenges and risks facing China today.

China is not like Japan in the 1950s, 1960s or 1970s in any meaningful way even if its current development level is much closer to Japan during those decades. Because of the serious imbalances China is much more like Japan in the late 1980s, with the major difference being that Japan never took debt, investment, and consumption imbalances to anywhere near the levels that China has taken them.

For this reason what we really have to consider when thinking about China is how these imbalances tend to be reversed. Since they were reversed in Japan in the period following 1990, Japan provides at least one possible model for China’s rebalancing process and, perhaps much more importantly, it demonstrates the kinds of pressures that China will face as it is forced into rebalancing.

This insight, by the way, extends to a lot more than just Chinese economic growth over the next decade. It is applicable whenever a system that has generated unsustainable imbalances is in the process – as it eventually must – of reversing these imbalances. In that case it is a waste of time to extrapolate from the development of variables during the period in which the imbalances were created to the period in which the imbalances are reversed.

With a change in the growth model comes a radical change in the relationship between underlying variables and their impacts on growth. It makes no sense to use the earlier data series, adjusting them according to new conditions, and to project new data series, because when a country is forced into reversing the imbalances, by definition all the correlations between relative inputs and outputs must fall apart, and the more extreme the imbalances that need to be reversed, the more untrustworthy the previous relationships. In that case it is much more useful to posit the various ways in which a reversal of the imbalances must occur.

Economic growth in Europe over the next ten years, for example, will not be anything like economic growth in the last ten years adjusted for changes in demographics, taxes, or anything else. We will be dealing with a Europe in which the tremendous debt, currency, and labour cost imbalances of the past decade must be reversed, and since the most likely form of the reversal will entail the breaking up of the euro, any growth predictions that do not at least acknowledge this chaotic rebalancing process are likely to be flimsy at best.

Likewise with predictions of US consumption growth, which will have to deal with reversals in the savings and consumer credit trends of the past decade, and with sharp change in two decades of housing behaviour. Predictions about the prices of hard commodities, which have to consider a major dislocation in the source of commodity demand since the early part of the last decade, are also likely to be highly unstable.

If you want to make economic predictions, in other words, whereas a long historical view will be very useful because it allows you to consider the dislocations created by a reversal of unsustainable imbalances, recent economic data are largely useless, as are predictions based on linear adjustments of recent economic data. Instead of projecting from past data you must model the various paths by which rebalancing can occur, and your prediction must be limited to those paths.

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management.

He blogs at
China Financial Markets.

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