China is weaker than it appears and “may be entering into an asset-deflation phase” like Japan’s, says a report today by two analysts at Bank of America Merrill Lynch. China has vaulted ahead of Japan to become the world’s second-largest economy after the U.S. But like Japan, says the Merrill Lynch report, China is marked by “imbalanced growth, government stimulus, overcapacity, an overwrought housing market, and a severely under-capitalized financial system.”
The report, called “Will China Repeat Japan’s Experience?” is by Naoki Kamiyama, an equity analyst in Japan, and David Cui, a strategist in Singapore. They say that the China of 2014 resembles the Japan of 1992, when a historic real estate bubble was beginning to deflate. “In general, it appears to us that the problem facing China today may be more serious than Japan’s in the late 1980s and early 1990s,” they write.
Japan’s lost decade of the 1990s came about when the Bank of Japan began raising interest rates in 1989 to prick a real-estate bubble. Higher interest rates coupled with a global economic downturn caused real estate values to plummet. Properties became worth less than the loans on them. Lenders, not wanting to acknowledge losses, kept extending fresh credit to property owners so they could pay interest on old loans. The economy slumped.
“Up until now, China has largely repeated Japan’s missteps,” Kamiyama and Cui write. Like Japan, China was overly dependent on exports, and the government resorted to stimulus when export demand fell in the financial crisis. That inflated an asset bubble, which China is seeking to deflate with tighter monetary policy. Now, they write, “the property market may be tipping over”—i.e., prices may be starting to fall. Bad debt is mounting. While the level of nonperforming loans in commercial banks still isn’t high, it increased more in the first half of 2014 than in all of 2013.
While Japan still has big problems, it began to climb out of its first lost decade in 2002 when the government of Prime Minister Junichiro Koizumi fixed the banking system under Finance Minister Heizo Takenaka. That involved the unpopular step of injecting public funds into banks that were revealed to be undercapitalized after writing off their bad loans.
Chinese leaders still haven’t wrapped their heads around the need to recapitalize the financial system on a massive scale, and China probably won’t get back on a growth path until they do, Kamiyama and Cui say. “We suspect that a key reason behind the slow action is that the new leaders are still consolidating their power,” they write.
“If this assessment is correct,” write Kamiyama and Cui, “we will unlikely see a resolution to the long-overdue bad debt recognition and financial system recap issue until the political dust settles. Unfortunately for the market, this appears to be at least a year or two away.”