[Takatoshi Ito] Is Japan-style deflation coming to China?

Recent economic news from China has triggered the same helpless, sinking feeling that gripped me when Japan’s property bubble collapsed in 1991-92. Will this sense of déjà vu continue, with China apparently heading down the same path of deflation and stagnation on which Japan embarked three decades ago?

Earlier this month, Evergrande -- the massive Chinese real-estate developer that defaulted on its debt in 2021 -- filed for Chapter 15 bankruptcy protection in the United States in the hopes of restructuring its dollar-denominated debts. (Chapter 15 allows a US court to intervene in an insolvency case involving another country.) And now the property developer Country Garden has missed $22.5 million in payments for offshore bonds and suspended trading in 11 onshore bonds, raising the prospect of a default.

These are hardly isolated incidents. China’s real-estate sector -- long a leading engine of GDP growth -- is buckling under the weight of falling prices, a huge and growing inventory of unsold housing and office buildings, and highly indebted developers. A property-bubble collapse seems likelier every day.

The implications for growth could be dire. Annual Japanese GDP growth amounted to 4-5 percent, on average, from the mid-1970s through the 1980s. After the property bubble burst, that rate sank to 0-2 percent. To this day, Japan’s economy has not recaptured its pre-bubble dynamism.

China is already experiencing a sharp growth slowdown. While it is perfectly normal for a fast-growing emerging-market economy to slow as income per capita increases, the scale of China’s slowdown in 2022 and 2023 is notable. In the second quarter of this year, quarterly GDP grew by just 0.8 percent, compared to 2.2 percent in the first quarter.

To be sure, second-quarter growth amounted to 6.3 percent in year-on-year terms, and the government’s annual growth target of 5 percent may yet be achieved. Nonetheless, China’s economic prospects appear to be dimming rapidly. Falling inflation -- the consumer price index declined last month by 0.3 percent year on year -- further darkens the outlook, as it points to possible deflation.

While China’s travails can be blamed partly on its delayed exit from its zero-COVID policy, weaker investment slowdown has played a major role. Foreign portfolio investors are pulling out of Chinese capital markets, and inward foreign direct investment is declining fast.

This is partly the result of the US-China decoupling. But it is also a reaction to China’s anti-espionage law, under which foreign businesses have been prosecuted for activities that are normal everywhere else in the world. It was under that law, for example, that a Japanese employee of the drug-maker Astellas was detained in March (he has yet to be released). Not surprisingly, foreign companies are finding it increasingly difficult to recruit employees willing to work in China.

The manipulation and obfuscation of data by Chinese authorities offers yet more reason for pessimism. China’s recent announcement that it would no longer disclose youth unemployment figures suggests that the level of joblessness among young Chinese people is truly dire. With even official data showing that China’s population began to decline last year, growing unemployment (and under-employment) can mean only one thing: the economy as a whole is weakening fast.

China’s demographic decline is its own cause for concern. As Japan can attest, a shrinking working-age population stokes powerful social and fiscal pressures, not least ballooning pension costs and worker shortages in labor-intensive industries, including medical and long-term care. Given decades of fertility-control policies, China will confront a much faster demographic transition than Japan did. And while it has expanded social-security protections in recent years, much more must be done to meet the demographic challenge ahead.

Two factors unique to China will affect how any economic crisis unfolds. First, because a large share of real-estate investment is carried out through so-called local government financing vehicles, the sector’s performance has a direct impact on public balance sheets. Debt held by LGFVs reached an estimated 57 trillion ($7.8 trillion) -- or 42 percent of GDP -- at the end of last year.

Given this, if a property bubble bursts, local governments will suffer severe debt distress, and may even default, potentially delivering a sharp blow to both domestic and international investors. To help mitigate the risks, the central government has authorized local governments to issue their own bonds, revenues from which can be used to repay LGFV debts. But, while this would improve balance-sheet transparency, it is ultimately just substituting one form of debt for another.

The second factor unique to China is that its biggest four banks are state-owned, so the central bank and the government can always step in to provide needed capital and avert a banking crisis. Repeated capital injections might be viewed as a sign of moral hazard. But only 20 percent of non-performing loans (NPLs) in China are the result of risk-management failures by banks; the rest are loans that were directed by the government or issued to distressed state-owned enterprises (SOEs). So, any bailout is ultimately just a case of the government taking responsibility for the lending it directed.

If the property bubble bursts, China’s banks and government must avoid the mistakes Japan made three decades ago. For starters, full and timely disclosure of NPLs is essential. Chinese banks must not succumb to the “evergreening” temptation and extend new loans to insolvent “zombie” borrowers so that they appear healthy. And where capital injections are needed, they must be delivered quickly.

Likewise, China’s government should be taking steps to stop the evergreening of SOEs and real-estate companies, and ensure that banks and LGFVs pursue debt restructuring, supported by capital injections if needed. Local governments should also be allowed to raise taxes, so that they can use the added revenues to pay down their debts.

If China fails to address the risks that are piling up in its economy, a Japan-style period of stagnation and deflation will become inevitable. And this time the entire world will suffer.

Takatoshi Ito

Takatoshi Ito, a former Japanese deputy vice minister of finance, is a professor at the School of International and Public Affairs at Columbia University and a senior professor at the National Graduate Institute for Policy Studies in Tokyo. -- Ed.

(Project Syndicate)