As they prepare for 2015, China's leaders should learn from the experience of Japan in 2014.
There is mounting evidence that Japan may have squandered its best chance for a meaningful recovery in more than a decade. The country is in recession again, foreign investors are losing confidence in Prime Minister Shinzo Abe's revival plan and deflation has returned. This week, the government approved a $29 billion stimulus package that it hopes will keep things from getting worse.
The travails of Abenomics should be a warning to President Xi Jinping of China, whose nation increasingly seems at risk of a Japan-like lost decade. Although speculation has focused on the "why" and the "how" of the Japanization of China's economy, the year ahead will provide clues to the question of "when."
China in 2015 is likely to look a lot like Japan in 1998. when the zombification of its economy truly began. The Japanese government had recently allowed Yamaichi Securities to crash, an epochal moment for a government that had spent the preceding decade resisting any kind of reform. The collapse of Yamaichi, a 100-year old institution founded at the height of the Meiji Restoration, was Japan's Lehman Moment, and suggested a new political will to force banks to write down bad loans from the 1980s. Then Japan lost its nerve. When Long-Term Credit Bank of Japan and other institutions teetered on the edge in 1998, the government rescued them. Many weak institutions and irresponsible bankers were propped up in subsequent years.
Rather than fix a financial system suffocating under liabilities and beset by complacent executives, the Japanese government chose to treat the symptoms of the dysfunction with zero interest rates and fiscal handouts. Abe's government is the latest to follow this tired strategy. For all his bold talk of reducing trade barriers, encouraging entrepreneurship and empowering women, Abe has spent the past year prodding the Bank of Japan to weaken the yen and his Finance Ministry to borrow more, an approach that merely papers over Japan's cracks.
To avoid a similar fate for China, Xi should begin by allowing some significant debt defaults. Xi has to contend with the world’s biggest corporate liabilities, estimated by Standard & Poor’s at $14.2 trillion in 2013, a figure that excludes the debt binge of 2014. As borrowing costs rise, an increasing number of companies will face failure.
The question is whether China will allow a Lehman-style purge to play out. So far, Xi has shown little appetite for defaults that might panic markets. China's first default in March was an encouraging sign, but officials have prevented additional ones since then. Yet the longer China puts off the inevitable, the worse it will be for the world economy.
“It’s necessary to let those zombie companies default,” Wang Ying of Fitch Ratings in Shanghai told Bloomberg News. “If there is no real default, risks will never be priced in a correct way.”
Xi faces a tough balancing act. The Chinese economy is set for the weakest growth in more than two decades and his task will be be to prevent it from slowing further. But achieving sustainable growth in the future will require painful and destabilizing shakeouts in the sprawling shadow-banking sector and state-owned enterprises addicted to easy credit.
The premier must find his inner Joseph Schumpeter, and embrace creative destruction. Along with letting some big companies fail, China should scrap its annual growth target. The obsession with meeting this arbitrary goal (7.5 percent this year) creates moral hazards as regional governments resort to borrowing to meet targets.
China’s runaway credit growth is hard to curtail because of the widespread belief that banks and risky investments will always be protected. That flawed thinking is particularly ingrained in state-owned companies that deem themselves too politically-connected to fail. If Xi can't alter that perception during the next 12 months, China may cross the line that Japan did 16 years ago.
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