I don’t agree with Mr. Das and I think he is off base in his conclusions. Having said that, we don’t learn much by only reading what we agree with.
April 18, 2013, 12:02 a.m. EDT
China is repeating Japan’s economic mistakes
Commentary: Wasteful investment and spending stunts growth
By Satyajit Das
A man reacts to stock prices at a brokerage in Shanghai.
SYDNEY (MarketWatch) — Despite a history of conflict and competition, China and Japan share development models. But if it is not careful, China may also share Japan’s economic fate.
Both Japan’s postwar economic recovery and China’s recent growth were based on exports and low-cost labor. Undervalued currencies gave exporters a competitive advantage, and exports were promoted at the expense of household income and consumption.
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In addition, China and Japan both encouraged high domestic savings rates, which was used to finance investment. Both countries generated large trade surpluses they invested overseas, primarily in U.S. government securities, to avoid upward pressure on their currencies and to help finance purchases of their exports. Both also used high levels of investment financed domestically to drive economic growth.
For Japan, the music stopped in September 1985 when the Plaza Accord forced the yen /quotes/zigman/4868099/sampled USDJPY +1.3962% to appreciate, reducing Japanese exports and economic growth.
In order to restore growth, Japan’s policymakers then engineered a credit-driven investment boom to offset the effects of a stronger yen, driving a bubble in asset prices that ultimately collapsed. Government spending and low-interest rates have since been used to avoid a collapse in economic activity, only worsening the imbalances.
Japan has been left with large budget deficits, very high levels of government debt, and enlargement of the central bank balance sheet, in part to finance the government and support financial asset prices.Read more: As Japan goes, so goes the world.
Banking crisis in the making
Until 1990, Japan was highly successful — growing strongly with only brief interruptions. Since 1990, after the bubble economy burst, Japan has been mired in almost two decades of uninterrupted stagnation.
China’s resistance to a sudden revaluation of the renminbi /quotes/zigman/4869230/sampled USDCNY -0.0748% is rooted in avoiding the Japanese experience.
Yet China’s response to the global financial crisis, which triggered a sharp decline in Chinese exports and slowdown in economic activity, is akin to that of Japan following the Plaza Accord.
Instead of government spending, China has sought to drive growth by a rapid expansion of credit from the state-owned banking system, which has driven an investment boom.
And like Japan before it, China’s banking system is vulnerable. Rather than budget deficits, China has used directed bank lending to specially targeted projects to maintain high levels of growth.
China’s reliance on overvalued assets as collateral, and infrastructure projects with insufficient cash flows to service the debt means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a significant portion of Chinese large pool of savings and income reducing the economy’s growth potential.
Moreover, at the onset of its crisis, Japan was a much richer country than China, and so had a significant advantage in dealing with the slowdown. Japan also possessed a good education system, strong innovation and technology, and a stoic work ethic that helped it adjust. Japan’s world-class manufacturing skills and significant intellectual property in electronics and heavy industry also gave it an edge.
In contrast, China relies on cheap labor, to assemble or manufacture products for export using imported materials. A labor shortage and rising wages is reducing competitiveness. China’s attempts at innovation and high-technology manufacturing are still nascent.
Chinese authorities admit that the credit-driven investment strategy has led to the misallocation of capital, unproductive investments and loan losses at government-owned banks.
In recent years, popular awe of the achievements of China has increased. But it is entirely possible that China’s spectacular success could end in surprising failure, as the country fails to make the needed economic transition.
The question now is can China avoid becoming the next Japan.
China faces significant challenges in moving from its investment-led growth model. Growth based on endless subsidized expansion of capacity is increasingly not viable. Attempts to continue the present strategy or adjustment may cause an economic slowdown greater than forecast, with consequences for China’s social and political stability.
The world assumes that China will continue its growth, albeit at a more moderate rate than in recent years. This view is based on what the global economy needs, rather than the facts. As the novelist C.S. Lewis observed: “If you look for truth, you may find comfort in the end; if you look for comfort you will not get either comfort or truth, only soft soap and wishful thinking to begin, and in the end, despair.”
Satyajit Das is a former banker and author of “Extreme Money” and “Traders, Guns & Money.”