Cross-posted from Kate Mackenzie and David Keohane at FTAlphaville.
In last week’s post about when does a growth deceleration become a crisis, we looked at the likely inevitability of change in China’s economic systems and growth rates.
While timing is difficult to predict, it does seem very hard to argue that the economic model can continue along with the social, political and legal status quo, all while maintaining recent high rates of growth.
Stephen Green, Standard Chartered’s chief China economist, wrote very clearly of four dynamic imbalances facing the country: the current approach to urbanisation; the investment/financial model; the relationship between government and provision of services; and the government’s role — what one might call the ‘crony capitalist’ problem.
China is often compared to other Asian countries that have moved from ‘emerging’ to ‘developed’ status, or almost, and so Japan is a natural comparison for China.
Lombard St Research’s Brian Reading and Diana Choyleva have put together a potted history of post-war Japanese politics and economic policy, and its implications for Japan.
Reading outlines the ‘command financial system’ that was in place from 1955 to 1993 in Japan, drawing on this BIS paper, which he highly recommends. Here’s a very brief summary of the characteristics:
1. Whatever was not specifically permitted was legally prohibited. Laws stated objectives and delegated general power to bureaucrats to specify what was permitted in order to achieve them.
2. Exchange controls stopped almost all inward and outward capital flows – foreigners were prevented from competing for Japan’s artificially cheap savings. Savers were prevented from obtaining higher rewards abroad.
3. Security and bond market intermediation was rudimentary.
4.The post-war American occupation authority imposed ‘Glass-Steagall’ separation between banks and security houses. Commercial banks were also separated from trust and long term credit banks (LTCB). City and regional banks made short term loans financed by short term (up to 2-years) deposits. They looked after big companies. Small banks and cooperatives, another banking sub-division, were limited to loans to small and medium sized businesses within their own catchment area.
5. The Finance Ministry comprehensively controlled most interest rates. They were set at discount or premium to the official discount rate, short or long term prime rates. Savers received minimal returns. Intermediaries were allowed comfortable margins to provide the weakest with an adequate return. Borrowers that had access to credit nonetheless obtained it cheaply.
6. The state postal savings system collected deposits in competition with the banks, with interest rates set separately by the Postal Ministry.
7. Non-financial companies were overwhelmingly financed by banks. Big business formed families, called ‘keiretsu’ with their main banks through share cross-holding and common board members.
He goes on:
The post war system served Japan well for two decades from the Korean War to the 1973-74 oil price explosion. Annual real GDP growth averaged 8¾% from 1952 to 1973. Then the growth rate more than halved to 3¾% in the years leading up to 1990 bubble bust. ‘Three strikes and you’re out’ changed everything.
Strike One. Structurally excessive private savings began to emerge in the mid- 1960s, generating deflationary pressure.
Strike Two. The breakdown in the Bretton Woods fixed exchange rates, following the 1971 ‘Nixon shock’, meant the yen could not remain permanently undervalued.
Strike Three. The 1973-74 oil price explosion permanently increasing energy prices, putting a brake on Japan’s capital-intensive industrialisation…
The persistent private savings surplus that emerged in the mid-1960s (shock 1) meant growth would stall unless a structural solution could be found.
Japan attempted three temporary solutions in response… what it got from them, says Reading was a burst bubble in 1990 and stagnation (with our emphasis in the last paragraph):
Temporary solution 1. Current account surplus
The excess savings could be lent to foreigners to buy Japan’s excess products. A foreigners’ financial deficit (Japanese current account surplus) would then absorb the private sector’s financial surplus. This was the solution to strike 1 in the late 1960s. But strike 2, Bretton Woods collapse, ruled this out as a permanent one. Foreigners are only willing and able to run deficits and debts for a certain period. When they cease to do so, the exchange rate appreciates. Strike 3, the oil price explosions, temporarily eliminated current account surpluses and absorbed excess savings by adversely affecting Japan’s terms of trade and thereby reducing real income. Reaganomics, US easy fiscal and tight monetary policy gave Japan a reprieve in the mid-1980s when the dollar soared (and oil prices also collapsed). The current account surplus reached 4% of GDP in 1986. But then the dollar’s fall led to ‘Endaka’, an ultra-strong yen. The current account surplus contracted, putting downward pressure on demand.
Temporary solution 2. Budget deficits
A public sector financial (budget) deficit could also temporarily absorb the private sector’s financial surplus. But again governments cannot build up deficits and debts indefinitely. Following the first oil shock the budget moved into substantial deficit, reaching 5½% of GDP in 1978. Thereafter the surplus diminished, rapidly when the foreigners’ deficit rose in the first half of the 1980s. Indeed the public sector moved into surplus by the end of the 1980s, but this was cyclical rather than structural.
Temporary solution 3. Inflating bubbles
Endaka led to easy money and asset price inflation. The credit explosion was one consequence of liberalisation. Rising financial wealth was a consequence and cause of increased private borrowing and spending. Companies invested more wastefully (20% of GDP) and ran larger financial deficits. Household savings had been on a downward trend since the oil crisis, and so had household investment. Nonetheless the household surplus shrank. But the second half of the 1980s bubble was concentrated in the company sector.
As with the other temporary solution, companies and households cannot run excessive deficits and run up debts indefinitely. Moreover bubble-fed borrowing leaves large losses when the bubbles inevitably burst. Losses end up with creditors, meaning bubbles invariably break banks. This is what happened to Japan. Stagnation, the default solution to excessive savings in the absence of structural reform, followed.
Diana Choyleva predicts China, having adopted many of the same approaches to creating and maintaining growth, will attempt to deal with various challenges with stop-start reforms and so far has “just gone down the route of the three temporary solutions that Japan tried and which failed.”
As she says, “the personal wealth and political muscle of a large number of those in power” will make it difficult to proceed in a linear fashion with broad reforms such as interest and exchange rate liberalisation, opening the capital account, cleaning up banks and changing the hukou system.
Indeed, this is arguably what we are seeing now. A new leadership that insisted it was comfortable with slower growth to facilitate a rebalancing gained praise for not immediately resorting to more stimulus measures seen in 2009 and 2011. Yet this week the premier has declared China will not ‘tolerate’ growth below 7 per cent (or 7.5 per cent, it’s a bit unclear).
China has so far followed in the footsteps of Japan. But its economy is not yet over-indebted. So there is time for China to avoid Japan’s mistakes if it changes course. The lesson from Japan’s experience in the 1970s and 80s is that change drives change and liberalisation becomes unavoidable. But unless policy is aimed at fundamental structural reform, the temporary solutions of running current account surpluses, budget deficits and spawning bubbles will eventually run out of steam and cause growth to stall. But China is far from having twenty more years to be blowing up bubbles.
Choyleva says rebalancing the economy by allowing household consumption to rise could ultimately be good for the Chinese Communist Party, something Michael Pettis also alluded to in our recent Alphachat podcast, in which he said household consumption could still rise with 3 per cent GDP growth.
From Choyleva:
As such the path of reform should support the legitimacy of the Communist Party. But for the common good, a large number of officials will have to go against their own business interests, personal wealth and political power. Much like Japan, the key structural imbalance in China is the featherbedding of business at the expense of households. China’s savers have been continuously penalised for the relentless industrial advancement of the economy with little regard for profitability, the environment or people’s health.
At the same time, Choyoleva says the party is also wedded to the idea of growth and many officials benefit directly from the status quo. While that’s possibly beginning to change, it does appear to remain a big conundrum and source of tension. It remains to be seen how much pain can be inflicted for longer term gain.
There is much much more to the analysis, which can be read in the usual place.
