In this latest issue we focus on the similarities and differences between Japan in 1980s and China today, and what these tell us about China’s future trajectory.
The parallels between Japan’s experience in 1970s-90s and China’s trajectory over the past ten years have become a topic of heated discussion. Whilst history never repeats itself, it does rhyme, and there is a sufficient degree of similarities between the two cases to warrant discussion and debate. What are the key similarities and are there crucial differences between the two episodes?We believe that there are five key similarities. First, Japan in the 1980s and China today had high national saving rates. Whilst this in part has been driven by demographics, most of the excess savings in China today and Japan in the 1980s were caused by deliberate suppression of consumption and its redirection to corporates that the state wished to foster. China’s savings rates remain the highest in the world (~47%). Saving rates in Japan averaged ~35%-40% through the 1980s. Second, such high saving rates forced both countries to adopt an aggressive external posture (trying to export as much of the savings as possible) and maintain high domestic investment (another avenue of allocating savings). Over the past decade, China has been investing ~45% of GDP (double the global average). Japan was investing ~35% throughout the 1980s. A significant portion of investment has gone into land and real estate (lower productivity-enhancing segments). Third, as returns declined, both countries started to record rapidly rising ICOR (incremental capital-output ratios), with Japan at one stage running ICOR of more than 9x whilst China is approaching ~7x vs. the global average of ~3x. Fourth, as returns declined, both countries started to leverage, with compressed bursts of credit over relatively short time frames. As returns declined and debt increased, velocity of money dropped. Fifth, both countries enjoyed a limited degree of external vulnerability (system flush with deposits).
However, there are also significant differences (negative and positive). First, Japan in 1990s was facing 17 years of a rapidly expanding global economy, as trading volumes expanded at a ~6% pa clip; shadow banking globally multiplied at an ~18% and cross-border finance accelerated at ~15%. Japan made an implicit decision to settle for a declining share of expanding global market. China does not have that advantage and needs to increase its share of static global trade (much harder task). Second, when Japan’s asset bubble burst, it was an extremely homogeneous country with a highly egalitarian income distribution; China on the other hand has income and wealth inequalities approximating Brazil. It is always easier to undergo a slowdown in a homogeneous and egalitarian society. Third, Japan had a well-established system of protecting property rights and an impartial judiciary, with public sector delivering service in an impartial manner. China lacks most of these ingredients. Fourth, Japan’s asset bubble was heavily concentrated in real estate and equities and its burst wiped out ~3x GDP. China has thus far avoided such concentration. Fifth, China maintains higher than average flexibility and unlike Japan’s protracted transfer of private debt to public sector, the bulk of China’s debt is already in state vehicles.
Most investors ask how did Japan’s episode end. The answer is that the jury is still out (25 years later). Whilst large, competitive and liquid countries do not go down easily, the lesson from Japan is that unless China embarks on robust domestic structural reforms and disconnects banks from its monetary policy, stagnation might be its best outcome. However unlike Japan, the social consequences of stagnation (or even rapid slow down) are likely to be severe. We continue to recommend China’s competitive private sector stocks.
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