AS the world debates whether the renminbi (RMB) is undervalued, the real concern is whether after the RMB revalues, China will repeat the mistakes of Japan during the 1985 post-Plaza Accord period.
In that decade, the yen rose from roughly 240 yen to one US dollar to as low as 80 by August 1995 and then depreciated to 147 in June 1998 before joint intervention stopped the depreciation worsening the Asian crisis.
During this period, Japan suffered the worst asset bubble with the stock market falling by more than 80%, land prices falling by over 60% and the banking crisis took nearly a decade before it was finally resolved.
The Japanese public debt rose to nearly 200% of GDP, one of the highest in the OECD countries and Japan had almost zero growth for nearly two decades, as interest rates were kept near zero.
The worst part of the Japanese dilemma is that with a huge overhang of the public debt and an aging population, Japan may face both a decline in population and also an implosion in the wealth holdings if interest rates were to go back to global levels.
Note that unlike the US, which has a lot of foreign debt owed in US dollars, the high level of Japanese debt is yen debt owed to its own citizens.
There are many foreign commentators who think that after the recent increase in credit in the Chinese banking system, equivalent to nearly 40% of GDP, with a broad money to GDP ratio of 180% of GDP, that China may be facing a Japanese-style meltdown.
What is the truth and what is the correct analysis?
In the period 1950-70, Japan enjoyed high growth, high capital formation, rapid monetization and rising property prices, very similar to what China is going through.
The interesting point is that monetization did not appear to be highly inflationary, so in the run-up to 1989 at the height of the asset bubble, the Bank of Japan was initially reluctant to raise interest rates.
Exactly like what happened with the US subprime bubble, there was also insufficient regulatory action to stop banks exposing themselves to real estate loans. Koyo Ozeki is Japan analyst for PIMCO and his analysis in December 2009 is very illuminating (www.pimco.com).
The amount of bank lending equivalent to nearly 40% of GDP also went into Japanese real estate between 1985 to mid-1990s.
In the case of Japan, most of it went into commercial real estate. Real estate loans to individuals for mortgages only accounted for 20% of the total credit growth.
What was interesting was his comparison of Japan (1985-91), US (2000-2007) and China (2003-2009).
During these periods, Japan and US grew roughly by 3% per annum, whereas China grew by 10%.
Real estate bubbles during this period were roughly 2 times in price growth for China and the US, but 5 times in the case of Japan.
He felt that since in China “there is overwhelming shortage of residential property that meets its new living standards; it will likely take a considerable amount of time for supply to catch up to demand.”
He “sees little risk in the foreseeable future that increase in loans to the real estate sector will pose a threat to the financial system”, but also recognizes that “a rapid increase in lending could lead to a rise in bad debt in the future.”
What were the Japanese policy mistakes during the bubble period and what can we learn from this?
One of the most distinctive features of the Japanese experience was how long it took to bring the banking crisis under control.
It was almost eight years after the bubble burst in 1989 before the first serious failures of banks forced the government to use public funds to prevent the meltdown in the banking system.
Hiroshi Nakaso, formerly from the Bank of Japan, wrote probably the best technical analysis of this experience for a paper for BIS in 2001.
Part of the problem was that no one understood the scale of the losses because there was a paradigm shift.
Richard Koo, the chief economist of Nomura Securities, called this a “balance sheet deflation”.
No one understood how serious the real estate bubble had on the balance sheet of the banking system.
I have argued that the real estate bubble is the elephant in the room – no single government department is in charge and current fragmented monetary and regulatory theory grossly underestimates the importance of real estate as collateral for companies and bank loans, income for local governments and wealth of households.
So when the real estate bubble burst, the damage to household, corporate, government and bank balance sheets is huge, but the effects may take a while to recognize in accounting terms.
Ozeki (2008) noted that it took the Japanese government a long time to recognize the asset deflation because most people assumed that the property prices would turn around after such low interest rates.
Secondly, the Japanese banks had large latent profits from their holdings of corporate shares that everyone assumed that they could cushion themselves from the asset losses. But the more the banks sold the shares, the lower the stock market prices became, creating a downward spiral in confidence and growth.
Thirdly, the cumulative bad debt problems were as large as 25-30% of GDP, in addition to actual write-offs amounting to 20% of GDP.
No one has an accurate number on the massive deflation of the Japanese real estate bubble.
Assuming that the US real estate/GDP ratio of 225% of GDP was the ratio for Japan in 1989 and prices deflated by 60%, then the wealth loss could be as high as 130% of GDP. Because these were commercial real estate, most of the losses were borne by the corporations, and those who could not finance their losses transferred it to bad debt for banks.
Given the fact that the banks had capital not more than 10% of GDP, it was not surprising that the Japanese banking system could not by themselves get out of the bad debt burden without large fiscal help.
Most analysts identify the new credit in China as being given to local government financing vehicles. This is the topic that I shall discuss in the next article.
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Datuk Seri Panglima Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia’s National Economic Advisory Council. He is the author of the book “From Asian to Global Financial Crisis”.
