Forecasts for China to surpass the U.S. as the world’s main economic power are misplaced. So says an observer who foresaw Japan’s eventual demise a year before its land-price bubble began to burst.
“The vulnerabilities in China today are very similar to the vulnerabilities in Japan,” said Roy Smith, 76, who was a Goldman Sachs Group Inc. partner when he wrote a column saying Japan’s rise as a financial hegemon was done. “Nobody agrees with me. But they didn’t agree with me in 1990, so at least I have one right.”
Among the risks: bad loans, overpriced stocks and a frothy property market are flashing danger for China’s economy and putting pressure on a fragile financial system -- similar to conditions that triggered Japan’s fall, said Smith, a finance professor at New York University’s Stern School of Business. A further parallel is the burden of an aging population, with mounting pension and health-care costs, he says.
While China probably will avoid prolonged Japan-style stagnation, a major crisis could expose weaknesses that aren’t apparent now, according to Smith.
“Most people today are talking about China displacing the United States as the great power of the 21st century,” he said in a telephone interview last week. “My view is that it is more likely to end up like Japan -- that is, the status of a former would-be superpower that isn’t.”
China surpassed Japan as the world’s No. 2 economy by gross domestic product in 2010 after three decades of rapid growth, fueled by the largest urbanization in history. It is tipped by many forecasters eventually to overtake the U.S. in output. By other measures, such as GDP per person, China is further behind the U.S.
On a per-capita basis, China’s GDP in 2013 was still just half of where Japan was in 1960, according to World Bank data. That leaves plenty of scope to catch up to rich-world peers, more optimistic observers say.
“The key difference I see between China now and Japan in 1990 is that China is at a much lower stage of development,” said Louis Kuijs, chief China economist at Royal Bank of Scotland Group Plc in Hong Kong, who previously worked at the World Bank.
Even so, China’s progress has confronted mounting challenges in recent years. In 2014, the economy expanded at the slowest full-year pace in almost a quarter century.
The slowdown has thrown a spotlight on a mounting debt pile that includes souring loans to local government financing vehicles, or LGFVs, which funded a boom in construction. Doubts about the creditworthiness of LGFV debt deepened last year, when Premier Li Keqiang started to pare back implicit guarantees for the regional financing units.
China’s total debt pile, including borrowing by households, banks, governments and companies, ballooned to 282 percent of national output in mid-2014 from 121 percent in 2000, according to an estimate by the McKinsey Global Institute.
“The Chinese financial structure is very fragile because a lot of it is misreported and will reveal a great deal of weakness when it comes out,” said Smith, who specializes in international banking and finance at the Stern School. “I don’t know when it is going to come out, but when it does it is going to have consequences and take away a lot of the world’s confidence in the Chinese system.”
Former U.S. Treasury Secretary Lawrence Summers is among those anticipating a further slowdown in China’s expansion. In October he published a paper co-written with fellow Harvard University economist Lant Pritchett that warned both China’s and India’s economies are at risk of a slump because high-growth periods in Asia typically revert to more-normal expansion rates -- often abruptly.
Some signs of stress are already emerging: Kaisa Group Holdings Ltd., a troubled real-estate developer based in the southern Chinese city of Shenzhen that must repay billions of dollars in borrowings this year, rattled investors by missing payment deadlines on a loan and a bond after the local government blocked several of its projects late last year.
“They say a rising tide lifts all boats -- a falling tide reveals all the rocks and slime,” said Smith. ‘There was a lot of it in Japan that people did not expect to see.’’
The former Goldman Sachs executive doesn’t claim to have a flawless forecasting record or to have been the only one who tipped Japan’s economic decline.
Still, his October 1990 predictions on Japan proved prescient. Made amid a tumble in the stock market that year, they preceded the pricking of the country’s property bubble. In a column in the New York Times, he assessed that Japanese manufacturers would shift production abroad and that the nation’s banks would be impaired by losses on property loans.
“Japan’s extraordinary economic and financial success has carried the seeds of its own undoing, some of which have rooted and are now beginning to bloom,” Smith wrote at the time.
He isn’t counting on a paradigm shift out of Japanese Prime Minister Shinzo Abe’s reflation program. Smith sees “some kind of twilight equilibrium” with economic stagnation and low inflation.
China’s leaders, who gather this week for an annual session of the national legislature, are trying to restructure the economy toward domestic demand led by consumption and services - - away from debt-fueled infrastructure. Economists anticipate a raft of reforms to state-owned enterprises as part of the push.
“China won’t end up in this peculiar Japanese no man’s land between growth and non-growth,” Smith said. “But I do think they could have an economic smash-down that could really set back the China dream and the China role as a global superpower in major ways.”
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