In his last column as the FT’s Asia Editor, David Pilling celebrates the rise of China. The parallels to Japan’s meteoric ascent — until the bursting of the bubble in 1990 — are worth spelling out, for they are often confused and conflated.
Contrary to frequent predictions, China’s growth model has not yet collapsed. Its growth spurt since Deng’s economic reforms is by some measures even more remarkable than Japan’s post-war economic recovery.
Although it is of course slightly arbitrary to pick certain time periods for comparison, it is telling nonetheless that in the 36 years from 1954 (the year after the Korean War, arguably year one of Japan’s “true” post-war period) until 1989 (the year before the bubble burst), Japan’s average GDP growth clocked 6.7% p.a.
Compared to that, China’s real growth rate for the 36 years from year one of Deng’s rule in 1978 until 2013 was a staggering 9.9%.
The reason China is still a developing, albeit “upper middle income” country according to the World Bank lies only in the lower base from which China had to climb at the beginning of its most recent catch-up growth spurt.
Despite China’s catch-up process still being incomplete, economically and politically we are feeling the ramifications of this unprecedented focal shift from west to east. Pilling’s column is about these ramifications, and the uneasiness many feel when pondering them, especially intensely, it must be said, in Japan.
Risks abound. They are political: China’s rise may lead to armed conflict as the world order of Pax Americana is challenged, in the Pacific and beyond. Environmentally, lifting 1.3 billion Chinese to the same living standards as gas-guzzling Americans may stretch the physical limits of Mother Earth.
These risks shouldn’t make us rejoice at China’s failure at achieving broad-based economic development though. Schadenfreude is clearly out of place, for the risks inherent to a failed transition are clearly huge.
And although the stakes are higher today, plus the fact that we’re dealing with an undemocratic regime, the parallels to post-war Japan are ominous, both in the rise and perhaps, as a warning sign, in the potential fall.
Japan’s rise to (economic) superpower status evoked fears of a looming Japanese 21st century, especially in the United States. Here, ageing industries feared their Japanese competitors, whose management practices were seen as superior. This language of awe came to fruition mainly in the 1980s and can be seen on some of the magazine covers I used as the title shot for this post.
With a pacifist constitution, little spending on military and the cold war alliance with the US, the fear of Japan limited itself to the economic and business sphere, but often drew from a somewhat racially-inspired imagination in the west. Often these imaginations were served intellectual fodder by the Japanese themselves, suffice it to refer the interested reader to the nihonjinron “theories”.
It is somewhat ironic that the fear of “Japan Inc.” peaked in the 1980s. By that time, the contradictions inherent to the Japanese economic model had become obvious: excessive gearing, lavish fiscal spending on inherently unproductive sectors and lagging growth vis-à-vis the high-speed 1960s and 70s signalled that the best was already over.
But Japan had avoided stepping into the middle income trap thanks to broad-based growth from a higher base, so maintaining the status quo post-bubble meant was easier than doing so in the midst of a painful and dislocating catch-up process. Its pork-barrel political system allowed interest groups to fall on soft cushions, financed by ever-growing fiscal deficits. Seen in retrospect, the Japanese brand of democracy weathered two decades of sub-par growth reasonably well.
China’s challenge may be more profound, and so are the ramifications for the world given the country’s size, its political ambitions, and its integration into the global economy, which is far bigger than Japan’s at a comparable stage in its economic development.
So is there anything China can learn from Japan? And if so, from which Japan? I would argue that we need to look chiefly at both the early 1970s and the mid-1980s. The former because the economic structure of today’s China is more akin to the Japan prior to the oil shock. The latter because the balance sheets of both sovereign and corporates resemble more closely the pre-bubble Japan of the 1980s.
That, unfortunately, is a dangerous combination. The economic structure of China still depends on heaps of capital-intensive investment, while the balance sheet of corporates and increasingly the sovereign may require too early a retrenchment.
China’s current economic structure and growth model depend on debt-financed investment. For one this is due to a high investment share to GDP, a low capital stock on a per capita basis, and falling returns on capital, as measured by a rising ICOR (incremental capital output ratio) and lower contributions of total factor productivity (TFP) to growth. Both concepts have their flaws, but do tend to point towards broad trends underlying the economy.
What this says is that investment in China has become comparatively less efficient than that of high-speed growth Japan. From the 1950s until 1973 (the year of the oil crisis), Japan’s ICOR was mainly below or at 3.0 (three units of investment yielded one unit of GDP), while investment as a share of GDP was at around 30%.
Then the ICOR grew, but so did the consumption component of GDP. This means that although investment became less efficient in GDP-generating terms, it didn’t matter so much anymore given that consumption and the external sector took over as the motor of growth. This is what one would call rebalancing.
In China, both ICOR and the share of investment to GDP have been growing, now to above 5.0 and 50% (these are rough figures), respectively. Ever more investment is needed to maintain rapid GDP growth. Exports as a share of GDP are already very high by international comparison, and cannot arguably grow further given international economic conditions. In fact, Chinese exports have been declining relatively as of late.
The problem of China’s growth model, then, is that it is too debt-dependent, and much of that debt is incurred by state-owned enterprises. And the bigger the debt, the larger the financial distress costs, as Michael Pettis has frequently argued. This weighs down heavily on growth, which in turn requires more debt-fuelled investment to keep up. A vicious circle in plain sight.
In short, therefore, we are interested in how Japan managed to rebalance its economy towards more consumption and less investment in the early 1970s. On the flipside, it is interesting to find out why Japan failed to avoid its corporate debt crisis and asset price bubble in the late 1980s.
Some of Japan’s rebalancing happened almost automatically: decreasing returns on capital signalled to (private) market participants to invest less. Capital returns were lower as the technological frontier was reached and the demographic transition concluded, with urbanisation rates reaching present-day levels. The corresponding boom in durable goods consumption (think TVs, microwaves, etc.) had therefore largely run its course.
Just because these factors occurred “automatically” in Japan does not mean that this is to be the case in China too. Here, much of the above is heavily politicised: First, less investment, hence lower GDP, has hitherto been unpalatable for the CP. Second, the demographic transition is far less advanced than what would be suggested by China’s current stage of development, chiefly due to the hukou system of household registration.
Yet Fukumoto and Muto argue that there are two further crucial variables in explaining the rebalancing in Japan’s early 1970s: the first one was the fast real wage increases that accompanied the inflationary period surrounding the oil shocks. The labour share of GDP consequently increased 10% from 1970-1975.
The extent to which Japan’s unions were strong and hence able to press for wage increases is difficult to gauge, and opinions diverge. Some neoliberal writers think that although without much formal power to their name, labour wielded considerable influence in corporate Japan. Others say that management was successful at coopting labour into almost full submission.
With steep oil price increases, the Japanese government asked labour to moderate its wage demands in order to combat rising inflation. And yet labour disputes were at an all-time high. These were not the political mass labour movements of the 1950s. And labour was successful in pushing through their wage demands, also because the economic structure had shifted much in the workers’ favour.
Clearly the implications are for China to increase wages. David Dollar, among many others, argues that the migrant worker / hukou system is responsible for at least a large chunk of the structural underpay of labour. Not having the same economic rights as their fellow registered urban dwellers, migrants settle for lower wages and consume less. China’s current cost competitiveness, however, is more profoundly explained by low labour cost than during early 1970s Japan.
Put differently, adjusting wages higher may be more painful for China today, although it may spur structural change into higher value-added sectors more quickly. Curiously, Chinese manufacturing wages have grown in excess of GDP growth over the past decade. The structural underpay, then, must come from elsewhere to explain the withering labour / GDP share, possibly the still-incomplete demographic transition from rural to urban areas as well as other sectors with slower wage growth.
The second factor, and probably the most important one, was that in Japan, higher costs of capital made investments pricier, thus fewer on the ground. This relatively simple transmission mechanism does not work in China today due to ongoing financial repression. Neither borrowing nor saving rates reflect the true cost of capital but are engineered to facilitate the transfer of resources from savers to investors with access to cheap credit, usually state-owned enterprises.
Yet Japan during the early 1970s was not a financially liberalised marketplace. The lessons should thus not be for China to, for example, undergo full capital account liberalisation. There are other, intermediate steps it can take to rein in excessive borrowing by state-owned enterprises. Yet all of them come at political costs, above all that of lower economic growth.
Back to Japan, it was the inflationary oil shock of 1973 that prompted Japanese policymakers to tighten monetary supply, thereby increasing the cost of capital. The returns on capital had already been on a secular decline for the “automatic” reasons described above. Taken together, the lowering returns on capital further decreased the investment / GDP share considerably over the coming years.
While holding much explanatory power for explaining a particular case of rebalancing, there is not too much China can, in the classical sense of the word, learn from Japan. Its institutions and structural conditions today are so much different. Organised labour faces different odds in China than in Japan. Financial and political repression go hand in hand in China.
As regards the second period for comparison, the mid-1980s, perhaps there are clearer lessons to be learnt here? The Economist argued a few years ago that China should let its currency appreciate gradually so as to avoid a costly one-off correction akin to Japan’s move following the Plaza Accord.
The negative effect of the rising yen was only averted due to ultra-loose monetary policy by the Bank of Japan. Coupled with meek macro-prudential supervision, an asset price bubble of unprecedented proportions formed: corporates borrowed, invested heavily in the real estate and stock markets, and the whole charade popped calamitously in 1990.
With the benefit of hindsight, five years after the Economist article went into print, the pressure on the RMB is for further depreciation rather than the other way around. This shows perhaps that this particular Japanese case study is of limited use for China today, too.
Japan’s was a stock market cum banking crisis that turned into long deflationary slump. China may not have to worry about the banking crisis part given the closed nature of its financial system and the overarching desire for stability of its political leadership.
In his latest newsletter, Michael Pettis argues, however, that the financial distress cost baked into the system are narrowing the timeframe Beijing has to effect a meaningful rebalancing towards the household sector. Higher growth now comes at the cost of higher debt and hence lower future growth.
The numerical model he builds lays out shows that at 6% nominal growth p.a. (which is lower than current actuals but at the extreme top of the feasible scale for the medium term according to Pettis), debt as a share of GDP would reach 274% in ten years. This is a level that no developing country can stomach without severe dislocations.
Japan in its pre-burst-bubble heyday had a credit/GDP ratio of about 160%, with corporates accounting for about two thirds of it (since then, the sovereign has jumped into the fold).
In order for meaningful rebalancing to happen, Chinese household income growth needs to eclipse GDP growth by around 2% to have a meaningful effect. This to Pettis is highly unlikely. And yet even under a 3% GDP growth scenario, debt/GDP would reach 251%, implying substantial financial distress.
This perhaps best symbolises the trap China may find itself. In order to control its debt levels, it may have to live with drastically lower GDP growth rates going forward. This may have to happen at a level of economic development far below than what Japan stood at at the time. Thus China may find it hard to avoid the middle income trap.
David Pilling rightly says that this hardly matters because the size of China still grants the country an extraordinary position in global political and economic affairs. Japan’s experience shows that catch-up is possible but perhaps not easily transferable into a 21st century context anymore.