Is China Turning Japanese?

China has formally overtaken Japan as the world's second largest economy. Yet, for all the recent excited commentary, there's less cause for baijiu toasts in Beijing than they might think. That's because China's economic growth has followed what's sometimes called "the Japanese model." In Japan and other Asian countries, this model has proved extraordinarily successful in the short term in generating eye-popping rates of growth -- but it always eventually runs into the same fatal constraints: massive overinvestment and misallocated capital. And then a period of painful economic adjustment. In short: Beijing, beware.

Japan's "lost decade" of the 1990s -- from which it still has not emerged -- followed a period of high growth, at the heart of which were massive subsidies for manufacturing and investment. The Japanese model channels wealth away from the household sector to subsidize growth by restraining wages, undervaluing the currency, and, most powerfully, forcing down the cost of capital. In every prior case, once the train gets rolling, it has been very difficult to correct course. That's because too much of the economy depends on hidden subsidies to survive.

Nor is Japan the only country to rise quickly and then suffer in this fashion. Brazil, which experienced "miracle" growth years during the 1960s and 1970s, had its own lost decade in the 1980s, for similar reasons. Beijing would do well to heed these tales of caution.

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MYSTIKIEL

8:26 PM ET

August 19, 2010

Welcome to what Waddill Catchings called the Suction Pump Effect

Scrooge McDuck might be happy swimming around in his big vat of cash but that big vat is pretty much dead weight as far as the economy is concerned. Far better to put it in the hands of ordinary punters who might actually spend it.

Income inequality is far too high in China. For a supposedly socialist country they are far too averse to getting out the tax stick and giving the big end of town a nice big whack with it. They are only spending it on veblen goods and ill-considered investments anyway.

The Chinese economy is like a game of Monopoly. The rich see the objective as being to buy up everything thats on offer. The problem is that in a game of Monopoly, when one player has bought up all the properties and collected all of the money, the game ends.

And in a Great Depression-type event, when a few people control all of the wealth of a country, the economy stops.

R5R6

12:45 AM ET

August 20, 2010

problem seen, no solution yet

It's human nature to pick the easy and less risky things unless a force against it is in place. Therefore, most likely, the mess will be left as it is, some attempts will show up from time to time, to convince the people that they are being taken care of, but that's the end of story.

Massive privatization? Yeah, it happened already in 1990s. IPOs, that's an efficient way to collect some free money to fix the troubles made by the overinvestment. And it's happening now as well.

GINA986

12:47 AM ET

Yes,I think China will

Yes,I think China will overtaken Japan several years in the future.

ARYABHAT

4:16 AM ET

Superb article

Brilliant analysis! FP needs more articles like this!

CARADOC

5:32 AM ET

Finally, some sense....

Excellent commentary...the meme has been out there for some time now that China will economically rule the world, and few have looked closely enough to say 'well, yes, sorta, maybe, kinda, BUT....'.

China's history is filled with examples of internal strife and fragmentation, coming often at the height of its so-called power. Tianemen Square was a revolution delayed, not derailed. Look for more upheaval...such unparalleled success can be challenging, if not self-defeating. What goes up, if not managed very carefully and with some luck, usually comes down with an almighty crash.

KRYPTER

10:23 AM ET

Wealth

Good article. China did go through a privatization phase in the 1990s, when communist housing and farming collective land was distributed to private owners. A lot of the wealth of the average Chinese family now resides in the paper valuation of those apartments and land parcels, which will only retain their value if property developers keep expanding at the insane pace they have been during the last 10 years. Which they won't, given the demographic constraints that are now appearing.

Investment was badly needed in China, but now overinvestment is in danger of generating very low or even negative returns.

I suspect the Chinese government will attempt to dump their problems on foreigners by initiating more export-oriented, mercantilist programmes. The resulting trade wars could get ugly, especially with a strong military and national sense of aggrievement permeating all of Chinese society.

MARTY MARTEL

1:55 PM ET

China is NOT Japan

There are several factors that Michael Pettis is overlooking:

1. The world has become way too dependent on cheap Chinese products. As long as China tightly controls its currency appreciation which it will, it is doubtful that China has to stop relying on its massive export machine. As latest trade figures show, China’s forex reserves have kept expanding and China is wisely grabbing up the resources worldwide. With its massive forex reserves, China is going to become a lender of last resort for many a countries and many a companies in the world. Only way this party will stop for China will be if the world decides to junk WTO which does NOT seem to be in the cards as of now.

2. With a one party dictatorship, China can retire its massive debts by fiat far more easily then a free market economy can. Witness how easily China has been rolling over massive bond holdings of its banks issued in 1990s.

3. Even when Japanese economy was expanding, Japan did not develop its military machine the way China is doing. In a way, Japan was indeed a paper tiger, being under US thumb ever since its defeat in WWII unlike China. China is ready to challenge US militarily. US is afraid of China the way US has NOT been of Japan since 1945. Further more UNSC seat with veto power gives China the political clout that Japan never had.

4. China has US, the world’s only super power by its tail. US businesses are hooked to huge profits that cheap Chinese products generate for them as a walk through any Walmart, Sears, Macy’s or Home Depot filled with cheap Chinese products proves. And US government is hooked to huge investments that China makes in US treasuries. Only country that engineer dollar’s crash in today’s market is China by stopping investments in US treasuries and massive selling of its own holdings of US treasuries. Japan can never dream of doing such a thing. As such China already seems to be moving in that direction with its recent reduction in the purchases of US treasuries.

5. China is literally engineering massive wealth transfer from US and Europe to Africa and Asia by pouring its dollar holding into purchases of natural resources.

Nixon must be turning in his grave for having created another power to challenge US by embracing China in 1972.

ALEXBC

7:43 PM ET

Not Really

1. Forex reserves and trade surpluses are misunderstood. They are not necessarily indicators of economic health, and in fact, have been indicators of weakness in the past, such as in the case of the U.S. in the 1920s, and Japan in the 1980s. More often than not, massive reserves point to economic imbalance: in fact, do you know who has the second largest forex reserve? Japan.

The world is not reliant on China for cheap products, so much as China is reliant on the world to buy them. The crises in the U.S. and the E.U. more or less forced China's hand into the stimulus, which in turn has brought forth many of the underlying weaknesses in the Chinese economy, such as overinvestment, low consumption, and income disparity.

China is also coming under increased competition from Vietnam, Bangladesh, India, and Indonesia in terms of low-wage labor.

Fixed currency policy is inherently unsustainable, and was a major factor in the collapse of the Asian Tigers in 1997. It creates low interest rates and hot capital inflows which cannot sustain themselves.

2. This is not true. China's phantom "crisis" of the late 1990s was souped up by Western critics (Gordon Chang et al). The current bubble is far bigger than the government; just read Andy Xie's assessment of China's real estate market. Mr. Xie correctly predicted the Japan real estate bubbles of the 80s, the Asian Tigers bubble of the 90s, the dot-com bubble, and the 2008 financial crisis. In fact, the longer the government attempts artificial control of its bad loans, the more dramatically catastrophic the denoument will become.

Skeptics of the 1980s Japan bubble similarly argued for the government's unfailing control over its banks, saying that it would not allow a crisis to happen. This is called "moral hazard" and has a long, proud history in the run-up to burst bubbles.

3. China cannot challenge the U.S. military at this point. It could disrupt U.S. presence in the Pacific, but the consequences would be dire. Much is made about the "carrier-killing missile" which is not only vaporware, but impractical given the U.S. Navy's broader capabilities to blockade China or launch retaliation via submarines. As for Japan: Japan's navy is larger than China's. Even while technically "disarmed," Japan has built a military force that is more than China's equal.

Another thing to consider is how much of China's security energies are directed towards its internal sphere: it spends at least as much on quelling potential disruptions at home, as it does in modernizing its military for potential external adventures. This drain on its resources will complicate its attempts to project external force.

4. You must be unaware that Japan owns nearly as many Treasuries as China. The idea of a China "sell-off" of Treasuries to collapse the dollar is naive: China would in turn watch its export market collapse, with the suddenly appreciated yuan weighing on it as the yen now does on Japan. Much noise is made about China moving away from exports to consumption, but this has not happened, not even a little. The auto market in China, for example, is set for about a 20% contraction over the last two quarters of the year, as subsidies expire and now drain household income as they are serviced. China's consumer class is about the size of France.

5. China is making a play for resources in Africa, but I do not see why this needs to be perceived as a threat. It is not transferring wealth away from the West, either. The West also maintains an enormous lead in terms of developmental aid.

ZHUUBAAJIE

2:41 PM ET

China is Miles Ahead

Looking at history can be instructive. But I think the author missed a hugely significant piece of more recent history. The cancer that caused the most recent worldwide financial meltdown has not been excised. Financial derivatives, which in 2009 was close to an astonishing $600 Trillion, and today the out of control train is hurtling towards a QUADRILLION US DOLLARS. That is US$1,000,000,000,000,000, or as divided by the 6 billion humans on earth, an astonishing US$160,000 per head. Put in another perspective - the ENTIRE GDP of the world totals only what, about US$50 Trillion a year - so this derivative casino is 20 times the size of everything that human efforts and capital generates each year. If the sun shines more by 5%, or too many leaves fall and clog up the Amazon, etc., THERE WILL BE tremendous losses for those gambling, and the bigger the financial institutions, the harder they fall.

Why is China ahead on this count? In the West, including Japan, the game has not changed. The banksters get all the profits in that derivatives casino, and the losses are socialized. But the cancer is so late stage, it is getting beyond the financial wherewithal of the respective governments to socialize the losses even if they want to - AND THE LOSSES WILL COME, it is inevitable. The Chinese banks, if you have not noticed, are the strongest in the world regardless of their lending practices - in comparison they have relatively low exposure to the fraudulent derivatives, and that continues to be the case.

The "health" (or really malignancy) of the financial industry of the West (+ Japan) is an oxymoron - they are mostly KAPUT today. Western and Japanese banks are actually already all dead - it is only with further creative reporting (rules changed so that derivatives are not required to be marked to market, but can be marked to whatever the banks would like them to be) that is outright FRAUD.

Unlike Japan, China has the internal market, it has the world's healthiest banks, and it has the world's most capable manufacturing base. It still has one of the lowest government "footprint" (public expenditures are less than 20% of the GDP). That is why investing in China today is the most attractive and rational alternative.

JAFDC

8:53 PM ET

Language

Brilliant commentary, as always. But 'goose' as a verb is not appropriate in a family newspaper. Maybe you meant 'juice'. Otherwise please just be clear and say 'Beijing may grab consumption by the balls and squeeze.'. Who knows, it might work.

DINGYIBVS

6:31 AM ET

August 21, 2010

Pure nonsense

You've gotta love how economists and pseudo analysts throw around random economic data to try to sound smart and predict the future. Short-term economics is a complex matter, but long-term it's not. Comparing two countries economies is in general a foolish exercise, because every little difference could in the end lead to entirely different outcomes, and none of these analysts can tell which one is the difference-maker until after the fact. Actually, many are just as clueless decades after the fact.

Let's stop for a second and go back to the basics. How has human race gotten wealthier over the millenia?

The answer lies in one word: Productivity

We as a species have come from being oftentimes incapable of feeding ourselves to having access to more luxuries than we even know exist. It was only a few hundred years ago when an average worker's lifetime of work amount to little more than enough food to feed him family, now we have factories of a few thousand workers capable of producing millions of cars over a person's lifetime. How did this happen? The western world has come from the dark ages just a few hundred years back to the leading powers of the world. How did that happen? How did this increase in productivity happen?

Again, the answer lies in one word: Technology

Sure, Japan's economy soared above its capabilities thanks to an investment bubble, but what truly limited them then and still limits them now is technology. Japan had peaked in technology by the early 1990's, it was no longer in catch-up mode where quick progress can be made by following in the footsteps of pioneers. They, by then, had to largely tread on the painfully expensive and and excruciatingly slow path of inventing and implementing their own technologies. In other words, they could no longer quickly and efficiently raise the productivity of its citizens. There are other factors, of course, but this is the essence of it.

Now, is that the case with China? No. Its citizens, on average, are still far, far less productive than their counterparts in developed nations. They are still behind technologically in many, many aspects, a gap which they can narrow with breakneck speed through well-publicized legal and illegal, ethical and unethical means. China will gradually stop growing when it catches up in technology, and more importantly, catches up in the implementation of technology and thus in productivity to the developed nations. By then, they have to invest in making its own innovations, and those innovations will come slowly and at at a heavy cost, just like how it is with the rest of the developed world. Bubbles like the current real estate bubble in China will only transiently move an economy higher or lower than where it should be, but in the long term, it is little more than a minor fluctuation in the general trend.

6:35 AM ET

Minor addition

I'd just like to add that the general economic trend may only continue with a stable sociopolitical environment, which seems to be the likely course for China in the near future. Either way, it won't be the economic policies that hampers China's growth.

HOWARDXUE

9:14 AM ET

The most important thing about privatization

Here is the most important thing about privatization, and a lesson should be learned from Russia of 1990's - How China can reach more fair wealth distribution through privitization.

If privitization means the state wealth go to the riches and make them richer, then privitization is not a good thing for the ordinary poor people.

Most possibly, the corrupt officials and elites with connections will gain most through privitization in China.

All in all, basic education, common healthcare and social service should be covered by the government, rather than being turned to profitable private business.

And, the government should play actively and put money on those long term strategic investments, such as high speed railway, next generation telecommunications, renewable energy, biotech, forestation, space plan, disaster rehabilitation and agriculture.