aranca views | china – the japan of the ‘80s?

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China – The Japan of the ‘80s? October 31, 2014

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Is China where Japan was in the 1980s? The jury is still out!

A slowdown in the world’s second largest economy and the probability of a potential hard-landing has been well documented now. We

believe China’s current investment appeal (read equity market valuations) too reflects the medium-term impact of a softening economic

growth. What, perhaps, is not a consensus currently is whether China is treading towards a ‘lost decade’, much like Japan in the 1990s.

What prompts us to think in this direction are a series of factors behind China’s recent strong growth bearing visible similarity to those

behind Japan’s economic performance in the 1980s. That being said, there are also factors where China differs from Japan and could

possibly avoid a near similar situation. The jury, it appears, is still out on this.

China GDP growth rate at constant prices (y/y) Japan GDP growth rate at constant prices (y/y)

Source: Japan Statistics Bureau, National Bureau of Statistics of China

The most glaring of the similarities is the expansion in domestic credit and its role in driving economic growth in both countries. Japan’s

domestic credit as a percentage of GDP expanded from around 1.8x at the start of 1980s and climbed up to as high as 2.6x by the time

economic growth started to taper off in the early 90s. China too has seen significant increase in the amount of credit made available in

the system. Total domestic credit to GDP in China has increased to nearly 2.0x from 1.2x at the start of the last decade. In fact, a

similar expansion occurred much more recently – 2009-2013, as part of the overall global economic recovery after the 2008 crisis.

Significant asset price inflation accompanied credit growth

The impact of such credit expansion has also been fairly similar in the two economies, i.e. a resultant asset price inflation, most notably

real estate. The Economist’s house-price indices for Japan and China show remarkable trends – from 100 in 1980 to 205 at the end of

1990 for Japan, and from 100 to 207 for China over 2000-2014.

Domestic credit/GDP – Japan Domestic credit/GDP – China


8.3%

12.7%

14.2%

7.7%

5%

7%

9%

11%

13%

15%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

4.2%

6.3%

7.1%

5.6%

0.8% 0.2% 0.9%

0%

1%

2%

3%

4%

5%

6%

7%

8%

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1.7x

1.9x

2.1x

2.3x

2.5x

2.7x

2.9x

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1.1x

1.2x

1.3x

1.4x

1.5x

1.6x

1.7x

1.8x

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

s




Economist – house price index comparison Urban Commercial land prices, y/y change – Japan


The chart on the right above shows the dramatic collapse in commercial real estate prices in Japan after nearly a decade of high credit

and strong economic growth. The sharp fall in the real estate prices in Japan also had a significant impact on the country’s financial

sector. A large portion of the credit in the market was collateralized against commercial and residential real estate and a drop in the

sector spiraled into the banking space. In China too, corporate debt, a big chunk of which is collateralized against real estate properties

(mostly commercial), has soared in the recent past. The current level points to corporate debt nearly 130% of the country’s GDP.

Will the real-estate sector be China’s Achilles heel too?

Should the real estate sector in China suffer a major downturn, its impact on the overall economy could potentially be material. Given

the trends seen in the recent past, it would be unwise to not be wary of such a possibility. In a recent note published by Aranca, “China

Property Market: Prepare for the End Game? – September, 2014”, analyst Nikhil Salvi points to a visible correction in the market and

possible steps being considered by the government to stem it. Sale of commercial real-estate was down by an average 9% in 1H2014

v/s a growth of 35% in 2013. Prices of residential properties fell on a m/m basis in 64 of the top 70 cities in July 2014 v/s just four in

2013 alone.

Investment in RE development, y/y change - China Fund sources for RE developers, y/y change – China

Source: National Bureau of Statistics of China

The impact from a softening real-estate market in China could not only impact the corporate sector and its economic growth, it is also

likely to inflate a certain degree of social unrest, given the existing affordability issues and lower disposable income levels in China

compared to Japan in the 1980s.

75

110

145

180

215

4Q

80

4Q

82

4Q

84

4Q

86

4Q

88

4Q

90

4Q

92

4Q

94

4Q

96

4Q

98

4Q

00

4Q

02

4Q

04

4Q

06

4Q

08

4Q

10

4Q

12

2Q

14

Japan China

-10%

-5%

0%

5%

10%

15%

20%

1988

1989

1990

1991

1992

1993

1994

1995

20.5

19.3

19.7

19.2

19.5

19.8 19.3

16.8 16.4

14.7 14.1

13.7

12

13

14

15

16

17

18

19

20

21

Jan

-Jul

Jan

-Aug

Jan

-Sep

Jan

-Oct

Jan

-Nov

Jan

-Dec

Jan

-Fe

b

Jan

-Mar

Jan

-Apr

Jan

-May

Jan

-Jun

Jan

-Jul

31.5

28.9

28.7

27.2

27.6

26.5

12.4

6.6 4.5 3.6 3.0 3.2

-

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Jan

-Jul

Jan

-Aug

Jan

-Sep

Jan

-Oct

Jan

-Nov

Jan

-Dec

Jan

-Fe

b

Jan

-Mar

Jan

-Apr

Jan

-May

Jan

-Jun

Jan

-Jul

2013

2014

2013 2014

2013

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China too suffering from an ageing population and a softening exports sector

For economies such as Japan and China and several other Asian nations, working population growth is a reasonable measure of how

steady and sustainable economic growth can be. China’s current working age population (15-64) is witnessing a steady decline in

growth, similar to what the early 90s in Japan. We believe China’s one-child per family policy, which has been in place for a number of

years now, has been the reason behind the plateauing working population.

Working population growth – Japan Working population growth – China


Another common ground between Japan and China has been their reliance on exports to drive the economy. While Japan’s export

industry softened largely as a result of the Plaza Accord which led to a stronger Yen, the resulting stimulus and expansionary policies

eventually caused the bubble to bust and further constrained the export industry. China on the other hand, appears to be consciously

controlling its exports and focus more on increasing domestic consumption. Given the difference in the demographics between the two

nations and given the recent drop in exports growth, domestic consumption patterns need to change meaningfully for them to support

overall economic growth.

Growth in exports, y/y change – Japan Growth in exports, y/y change – China


Further, we believe that China’s competitive advantage in its exports industry has a long-term declining trend given the rising labor

costs, production costs and increased focus on climate control and environmental issues globally. While Japan suffered from a

structural appreciation in Yen especially after the 1985 Plaza Accord, Yuan’s appreciation has been much more gradual. That being

said, rising labor costs in China have acted as a double whammy making exports a lot more uncompetitive now than a few years ago.

0.7%

2.2% 2.0% 1.8%

0.3%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

0.7%

2.0% 1.9% 1.8%

-0.8%

0.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

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China labor cost and currency movement Significant appreciation in Yen post Plaza Accord


Where there are similarities, there are differences too

While there are some striking similarities in the growth recipe for China versus what Japan experienced in the 1980s, we list down

some differences too. While some may apply the much clichéd ‘too big to fail’ argument in China’s case as well, we do note some

structural differences in the two economies as well.

China remains relatively below-par when it comes to urbanization levels. A good percentage of the population still lives in semi-urban

and rural areas and presents an opportunity to push for higher domestic consumption through increased economic standards. Also,

China’s current urbanization levels are similar to what Japan had in the early 1970s. A rapid increase in Japan’s urban population

played a crucial role in driving the country’s economic growth in the 1970s and mid-1980s.

Urbanization percentage – Japan v China GDP per capita – Japan v China (USD)

Source: World Bank

The other major difference and partially a result of the lower urban population, is China’s significantly lower per capita GDP compared

to where Japan was in the 1980s, nearly 1/6th currently. Both these factors for China were present in case of Japan at a time when the

latter was at the cusp of a continued high growth phase.

Another important point to note is China’s current population employed in the agriculture sector. With as much as half the population

living in semi-urban and rural areas, the agriculture sector currently supports nearly 30% of the country’s population. The percentage

has steadily declined over the past three decades, but still remains sizeable. Japan on the other hand had nearly 90% of its population

employed by non-agriculture sectors in the 1980s. We believe that a higher agriculture employment presents a few opportunities – 1)

65.0

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

90.0

110.0

130.0

150.0

170.0

190.0

210.0

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b-0

1

Jan

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2

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3

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6

Jul-0

7

Jun

-08

Ma

y-0

9

Ap

r-10

Ma

r-11

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2

Jan

-13

Dec-1

3

Labor cost index USDCNY

20

30

40

50

60

70

80

90

100

110

Ma

r-80

Jan

-81

Nov-8

1

Se

p-8

2

Jul-8

3

Ma

y-8

4

Ma

r-85

Jan

-86

Nov-8

6

Se

p-8

7

Jul-8

8

Ma

y-8

9

Ma

r-90

Jan

-91

Nov-9

1

Se

p-9

2

Jul-9

3

May-9

4

Mar-

95

USDJPY

78 53

0

10

20

30

40

50

60

75

76

76

77

77

78

78

79

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Japan China

35,451 6,807

0

1000

2000

3000

4000

5000

6000

7000

8000

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Japan China

s




China agriculture employment trend

Despite a steady decline, China’s current agriculture

employment still remains high at around 30%

We believe this offers opportunities for China:

1) A shift to urban and non-agriculture employment could

increasing domestic consumption and mitigate the

impact of softening exports

2) a shift from agriculture to non-agriculture employment

would also offset the ageing working population

Source: World Bank

it gives China the opportunity to increase the economic standards of its average populace, thereby increasing domestic consumption

and mitigating the impact of softening exports, and 2) a shift from agriculture to non-agriculture employment could take care of the

ageing working population in the urban areas, an advantage which Japan did not have in the 1990s when its economy began tapering

off.

We also believe that, given the above factors, China does have room to grow out of the middle-income group into a well-diversified

higher earning, spending and consuming upper-middle class. We note that, although there are striking similarities between the current

Chinese growth scenario and the Japan of the 1980s, there are opportunities that can help China avoid a prolonged limp in growth.

That being said, a lot of these structural opportunities need to be exploited with prudent government policies and controlled and

measured investments. Although a ‘lost decade’ for China may still remain far-fetched, it remains to be seen how the rest of the decade

unfolds and whether the current hawkish investor stance changes.

Policy measures that can avoid a Japan-like scenario and capitalize on the favorable differences:

Despite the setup in China being a lot similar to Japan prior to its ‘Lost Decade’, what differs in China’s case is the government’s

intentions, although partial, towards taking a tough stand and implement non-populist measures. We believe that, being a non-

democratic government is a key differentiator that could make China well equipped to provide a ‘soft-landing’, should the need arise. To

this effect, the government has already implemented some preemptive measures like liberalizing the economic sectors in a timely

manner, reducing state’s dominance and reforming the financial system.

The extent of growth in unproductive capital formation in China is much greater than what Japan had at a similar phase of development.

The overinvestment in China has largely been driven by the lower rate of borrowing that the state-owned entities have enjoyed, coupled

with the benefits of monopolistic pricing and government subsidies. Withdrawal of these state-sponsored economic moats would make

these entities financially unviable, leading to pile up of nonperforming loans and bond defaults.

However, we believe the following factors are favorably stacked up in China that would help it avoid a fate similar to that of

Japan’s:

Growing international pressure to reduce its massive trade surplus would mean appreciating its artificially undervalued

currency. With the export story hinging on the currency competitiveness, the country has been gradually scaling back on its

protectionist measures, thereby placing a cap on the over investments in sectors with over capacity

Unlike Japan, where developed domestic markets were already saturated to absorb the output that lost its export sheen, China

has a relatively developing domestic market. This would likely absorb the surplus output from the already installed capacities

thereby providing a cushion and reducing the prevalence of bad loans.

Chinese authorities also seem to be actively involved in instilling confidence by taking proactive and non-populist measures,

something that lacked in Japan’s case. Measures like Chinese Central Bank injecting 500 billion yuan into the country's

25

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40

45

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55

60

65

70

75

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undercapitalized top banks (providing buffer against the increasing bad loans) and expanding the municipal-bond market

allowing localities to refinance with direct bond sales will boost sentiment in the financial system. Property markets have also

seen measures like improving mortgage loan criteria and increasing tax rates to reduce speculative purchases to address

asset bubble concerns. Meanwhile, Pension scheme reforms of uniting the urban and rural systems, would see increased

public funds lending support to the local markets.

Curtailing Shadow Banking: Shadow banking has been one of the primary concerns, which is estimated to have artificially kept the

interest rates lower. Smaller banks in China, faced with stringent competition, have been more aggressive to adopt shadow banking,

fueling growth for interbank activities. With a view to instill confidence in the financial system and stem the growth of shadow banking,

policymakers recently tightened market liquidity to address alarming levels of interbank funding transactions. Beijing has also been

tightening its policy on wealth management products, cross-border arbitrage flows and the bond market aimed at curbing the money

flow into the riskier shadow banking activities. Initiatives like these are an indication of the government’s intent to tackle the growing

public debt menace and avoid a fate as that of Japan’s. We believe such measures would see China continue on a path of growth,

which although might be lower than the standards it achieved in the past three decades, but would be safer than the path Japan found

itself on.

Shadow banking– China

Some of the policy actions taken by the government to

curb the growth in shadow banking in China include:

1. Regulations on wealth management products by issuing

accounting rules for banks for such products

2. Less aggressive stance on injecting liquidity in the

system in a scenario of sudden spike in interest rates

3. Stronger auditing of local government and municipality

debt

4. Setting up a financial regulation coordination entity

under the purview of the PBoC and other financial

institutions

Source: National Bureau of Statistics of China

Research Note by: Avinash Ganesh Singh with contribution from Lekha Badlani, Nitisha Pagaria and Tushar Patil

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5,000

10,000

15,000

20,000

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Regulated lending Unregulated lending(CNY bn)

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