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As China’s economy sputters, investors are asking whether the country could repeat Japan’s experience in the 1990s. Goldman Sachs Research finds that even though there are some key similarities between the two situations, China’s “Japanification” is far from certain.
While deteriorating demographics, a debt overhang, and an asset-bubble-burst were all important ingredients to Japan’s malaise at the turn of the century, a key contributor to its Japanification was a fundamental change in longer-term growth expectations, Goldman Sachs Research China Economist Hui Shan writes in the team’s report. She says growth expectations in China, which is also coping with worsening demographics, a debt overhang, and a deflating property market, are showing signs of a downward drift, but there are ways policymakers can avoid a Japanese-style slump.
“The key to avoid such a negative feedback loop is to cut off the continued deterioration in longer-term growth expectations,” Shan says. She points out there are bright spots in the economy, including investment in electrical machinery in the manufacturing sector and an increase in making precession instruments and cars. Policymakers’ will have to manage the outlook for GDP growth as the world’s second-largest economy transitions from one of its important economic engines — property and infrastructure investment — to a new one based on upgraded manufacturing and self-reliance.
“During this process, growth is expected to be soft before the new engine reaches a scale that is comparable to the old engine,” Shan says. Inflation will probably be muted because of the unfavorable demand-supply balance, and nominal interest rates will need to stay low to facilitate the deleveraging of the old economy. “These are mild symptoms of Japanification that will stay with China for at least a few years in our view,” she adds.
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How China compares to Japan in the mid-1990s
By some measures, China’s situation looks even more dire than Japan’s did some 30 years ago, according to Goldman Sachs Research. For starters, China’s crude birth rate (the ratio between the number of live births in a year and the total mid-year population) has fallen further — it declined to 0.75% in 2022, considerably lower than Japan’s 0.99% rate in 1990 — and medical experts believe it may not have bottomed yet.
Weakness in China’s housing sector also looks more pronounced. The urban residential property vacancy rate is around 20% in China, more than double the 9% rate that Japan endured in 1990, and housing prices are more stretched at 20 times household income in China, versus 11 times in Japan in 1990. Given that residential investment represents about twice the share of China’s GDP compared with Japan in 1990, “the direct impact from a housing slump to the real economy would be bigger in China than in Japan,” Shan says.
That said, there are ameliorating circumstances that suggest China may be able to avoid a prolonged downturn. China’s property slump isn’t being accentuated by a stock market collapse, as was the case for Japan in early 1990, when plunging share prices severely damaged its banking system. China will likely continue to enjoy steady population growth in its urban centers, due to its still-low urbanization rate, even as its overall population declines. And, with a significantly lower GDP per capita, China’s economy also arguably has a higher potential growth rate than Japan in the 1990s, “which should make the deleveraging process less painful,” Shan says.
In addition, healthy Chinese companies, unlike firms in Japan in the 1990s, aren’t reluctant to invest because their balance sheets are impaired, but rather because of regulatory tightening and policy unpredictability. Japanese banks were able to procrastinate in dealing with non-performing loans and provide forbearance lending to zombie companies.
“The Chinese government does not face the same political costs that the Japanese government did, but its preference for commercial banks to absorb a large share of losses in property and local government implicit debt may nonetheless constrain their credit creation ability,” Shan says.
The real reason for Japan’s economic stagnation
Then there’s the question of just how much of Japan’s woes in the 1990s were tied directly to demographics. Businesses saw demographics exerting downward pressure on long-term growth expectations and pulled back on spending and increased saving, creating a negative feedback loop. In fact, most of the decline in Japan’s potential growth rate in the 1990s can be explained by the falling contribution of investment on worsening growth expectations, Shan says. By contrast, labor’s contribution played a relatively small role.
“Deteriorating long-term growth expectations rather than deteriorating demographics were at the core of ‘Japanification,’” she says.
The latest data coming out of China suggests expectations have weakened materially over the past 18 months. Private investment, for example, stopped increasing after early 2022 and contracted outright in 2023. Likewise, consumer confidence plummeted during the Shanghai lockdown in April 2022 and has stayed depressed since. “The lack of coordinated and forceful policy responses has led many forecasters to downgrade their medium-term growth outlook for China,” Shan says.
There are steps China can take to counter that pessimism, according to Goldman Sachs Research. The government could emphasize the importance of economic development, accelerate the restructuring of troubled property developers and local government financing vehicles, and strengthen social safety nets to encourage long run household consumption. They also caution that commercial banks shouldn’t be made to shoulder most of the loan losses during property deleveraging to protect their ability to extend new credit, among other steps to provide greater policy certainty.
“Policy predictability and coordination are important for investment demand from the private sector,” Shan says. “The Chinese economy doesn’t have to follow Japan’s path in the 1990s.”
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Originally published at: Goldman Sachs