China would do well to heed the lessons of Japan, Stephen Roach argued during a recent visit to the China-Europe International Business School (CEIBS) in Shanghai. The distinguished Mr. Roach, formerly Morgan Stanley’s chief economist and now faculty at Yale University, unfortunately was not referring to Japan’s ground-breaking work in the fields of robotics or vending machines. He was talking instead about Japan’s tumble from its position as the first of Asia’s modern growth miracles in the ‘80s into decades of economic stagnation beginning in the ‘90s.
The similarities between Japan’s economy at the time and China’s current model are striking: Both countries had tightly managed (read: undervalued) currencies and followed a mercantilist model of export-led growth. This growth model triggered an upsurge in their current account balances and dollar assets.
In China, however, many characteristics of the Japanese economy are writ large. Whereas Japan’s exports peaked at 15% of its GDP in 1984, China’s exports surpassed 35% of its GDP in 2007. Likewise, Japan’s current account balance topped out at 4.5% of GDP in 1987, while China’s climbed to 11% of GDP in 2007.
What should China be jotting down from this history lesson? One clear takeaway, according to Roach, regards its currency. Under pressure from the West, Japan signed the Plaza Accord in 1985 in which it agreed to appreciate its currency by 50% over the next few years. This move led to a sharp devaluation in existing investments, one of the main factors in Japan’s decline. Private non-residential investment fell from more than 75% of Japan’s GDP in 1990 to 70% in 1994 and then continued to decline further.
With the threat of an asset bubble lurking behind China’s gleaming new factories and commercial spaces, the lesson is clear: China should not bend to pressure to appreciate its currency too fast, no matter how furiously Chuck Schumer fumes and stamps.
The second lesson is to take steps to deflate bubbles. Bubbles have been around since before the Dutch were dealing in tulips, and it’s often impossible to prevent them. However, once leaders become convinced a bubble is likely to hurt the real economy, they should use policies to limit them, said Roach. China is doing this by limiting mortgages and sales in real estate, but could make a more concerted effort to stamp out relationship-based lending in the banking sector.
This is also a warning against complacency. Bubbles have everything to do with irrational exuberance and a failure to calculate risk. One would think that if anyone could reinvent the wheel, it would be the Japanese. At the time, Japanese leaders were also convinced that they had discovered a miraculous new growth model. But according to my former colleague Greg Kobrick at Pacific Epoch, this is the same faulty thinking that permeated the internet industry during the bubble of the late 90s.
Guarding against complacency is a tricky prospect, but China’s five-year plans do present a powerful tool to keep the country on track. Roach remains optimistic about China’s ability to gradually shift its course of growth in line with the 12th Five-Year Plan and dodge Japan’s fate.
China plans to accomplish this shift by scaling up consumption, which will allow its service sector to drive GDP growth. This is an option that Japan, a small country with only one-tenth of China’s population, never had.
I am more skeptical than Roach about China’s ability to complete this transition. China would need to build an adequate social safety net to convince its people to spend and push up interest rates to stamp out the investment-driven growth that has led to an oversupply of infrastructure – these are both precursors to empowering the Chinese consumer. To paraphrase William Stafford, justice will take about 1.3 billion intricate moves.