Why Japan's 'balance sheet recession' won't hit China

A significant increase in credit and extreme optimism led to the formation of Japan's economic bubble in the 1980s, which later ballooned due to a loose monetary policy, the pro-cyclical effect between financial and economic activities, and a sustained rally in land prices prompted by the land tax system.

In 1990, due to a tightening monetary policy and sharp declines in land and stock prices, the bubble began to pop. The Asian Financial Crisis of the late 1990s, coupled with post-bubble blues, worsened the business environment, with rising recessionary pressure on the Japanese real economy.

In 1991, the Bank of Japan adopted a raft of policy measures with the chief aim of defusing the potential insolvency risks of financial institutions. Meanwhile, it continued to execute a relaxed monetary policy.

Despite these, Japan's GDP growth in real terms has barely topped 3.5 percent since 1991, trailing other economies of the Group of Seven for most of the time. The effect of this policy mix can hardly be described as effective.

Japan suffered from sluggish economic growth and recession for a decade, a phenomenon dubbed as the "Lost Decade". However, in terms of actual economic growth, it is more appropriate to call it "Three Decades of Change".

To explain the failure of monetary policy and the reason why the Japanese economy was not growing, economist Richard C. Koo put forward the concept of "balance sheet recession" — a groundbreaking assessment from summarizing the shared experience of the United States and Japan.

The underlying logic behind the theory of a "balance sheet recession" was that the private sector undergoes great insolvency as a result of a plunge in asset values, including stock and land prices. Private businesses are committed to debt minimization rather than profit maximization. Therefore, the private sector — despite the constantly lower financing costs due to the easing monetary stance — will only raise funds to pay for outstanding debt, rather than scale up investment or consumption.

Unborrowed savings from this repayment of long-term debt will result in funds sitting idle in the financial sector, and aggregate demand will spiral downward, thus inducing deflation.

The GDP will continue to shrink until the private sector completely repairs its balance sheet or is no longer able to increase new savings. Since monetary policy has partially failed, fiscal stimulus may be the most forceful way to help businesses walk out of the "balance sheet recession".

In addition, due to the highly persistent "scarring effect", the private sector would be extra cautious about debt following a long and painful deleveraging process.

So, fiscal stimulus needs to be provided on an ongoing basis over the long term with well-focused tax and fee cuts to encourage the private sector to invest and consume.

China's case

China has not yet entered into a "balance sheet recession". This assessment is based on the analysis of the Japanese economy before and after the bursting of its economic bubble in the 1990s, and a discussion of the basic logic of "balance sheet recession" and relevant policy measures.

Home price filings and land sales, which are both led by the government, make China more capable of navigating asset price fluctuations.

As a result, the likelihood of private sector insolvency triggered by a sharp fall in asset prices has been weakened.

The overall downturn in the domestic real estate sector since 2021 has been a cause for concern. Yet, the country has a long-standing pattern of relying on expensive residential land grants to subsidize the relatively cheaper grants of commercial and industrial land.

Data from January to May this year show that the average sale price of residential, commercial, and industrial, mining and warehousing land was 7,598 yuan ($1,061), 2,720 yuan and 340 yuan per square meter, respectively.

According to macroeconomic data provider CEIC, private consumption contributed only 38 percent to China's GDP in 2021.

Unlike Japan's heavy reliance on the private sector to increase leverage and expand domestic demand prior to the bubble, China has not resorted to massive stimulus. So, the decline in residential land values from 2021 will not trigger a systemic "balance sheet recession" in the country.

Moreover, the main reason why Chinese residents rush to pay off loans ahead of schedule is because of a lack of investment products with high returns, not due to household insolvency.

For example, from January to end-May 2023, the number of equity hybrid funds with positive returns accounted for only 38 percent of all such funds.

Currently, the domestic economy is facing considerable pressure, including a middle-income trap, dampening overseas market demand, a rapidly aging population and government debt risk.

The authorities should leave ample space in advance to effectively maneuver fiscal policy as and when needed.

China's per capita GDP in 2022 exceeded 80,000 yuan, close to the high-income national standard set by the World Bank in 2021($12,695). A rise in labor costs may weigh down China's cost advantage in exports. Although the nation has a more complete industrial chain — a competitive edge that regions such as Southeast Asia will find difficult to catch up with in the short term — the middle-income trap remains a major concern.

But trade protectionism has gained ground in some Western countries lately, and China's exports face excessive entry barriers in overseas markets.

In addition, an aging population is a critical issue that China has to deal with.

By the end of 2021, there were 267.36 million elderly people aged 60 and above, accounting for 18.9 percent of the total population, up from 14.3 percent in 2012.

In general, consumption demand from the elderly group is lower than that of the young-adult group. The pressure on aggregate domestic demand brought about by an aging population and a declining birthrate needs high attention.

Besides, the risk of government debt, with a special focus on local government financing vehicles, needs to be addressed without delay.

Since 2021, as declining land transfer revenues continued to weaken government financial strength at the primary level, pressure on debt payment of local government financing vehicles in certain regions has been brought to the fore.

To resolve government debt in a market-oriented and rules-based manner, a method of leverage transfer could be employed. Any debt risk can be shared fairly among debtors and creditors, and the principle of "no bailout from the central government" should be strictly adhered to.

From a creditor's point of view, the net withdrawal of the non-banking portion of the bonds may be compensated by other local financial resources. What's more, hidden debt could be swapped and kept on the books to improve the financial sustainability of local governments.

Lu Zhe is chief macroeconomist and Liu Zibo is a macroeconomic analyst at Topsperity Securities. The views don't necessarily reflect those of China Daily.