Zombies once destroyed Japan’s economy—now they’re infecting China’s

China's Transition
China's Transition

America’s global dominance is fading—and a rising superpower in the East is poised to take its place. Renowned for their formidable work ethic, savings habit, discipline and math skills, its workers are already putting Westerners out of jobs. It’s the world’s second-biggest economy, and the question isn’t whether it will oust the US from its perch, but when.

Nope—we’re not talking about China, but 1980s Japan.

Anxiety around China’s rise today is a déjà vu of how the world’s leading economies once felt around Japan. But that rise could become a replay of Japan’s subsequent decline and stagnation, says Patrick Chovanec of Silvercrest Asset Management, an expert on the Chinese economy.

“There are striking similarities between China and Japan in the 1980s and ’90s, and they’re not superficial,” he says. “They’re two very different countries but they ended up with a banking system that basically produces the same result—the outcome being a rapid deceleration of (hitherto high) growth, as well as zombie banks and corporations.”

Chovanec is referring to what happens when, during economic slowdowns, banks or the government refuse to let unprofitable companies die, keeping them alive on a steady drip of new credit. Japan’s decade of the living dead began after its export-led boom abruptly ended, leaving the country hooked on credit before it had developed market mechanisms to keep that borrowing bonanza in check.

China too has gone on a credit-fueled investment bender as its export-led boom has faded. The prevailing assumptions about what happens next are that China will either suffer a US-style banking crisis that forces unprofitable corporations to the wall, or implement reforms that keep it growing at a healthy clip.

But it’s actually likely to suffer a fate more like Japan’s: a “zombie infection” in which large companies feed off credit while the economy stagnates. To understand why, though, it’s important to grasp what China’s rise has in common with Japan’s—and how it’s already exhibiting the same symptoms.

China and Japan: by the numbers

Even comparing headline data, the Japan of the 1980s and China of today are strikingly similar:

  • Second-largest economy. In 1968, Japan unseated West Germany (paywall) as the second-biggest economy on the planet. China seized that title in 2010, with its nominal GDP of $5.9 trillion nudging past Japan’s $5.5 trillion.
  • One-tenth of global GDP. By the early 1990s, Japan’s economy accounted for 10% of global GDP (in purchasing-power parity terms, via the IMF), a milestone China hit in 2007.
  • One-tenth of global trade. In 1986, Japan accounted for 10% of global trade, a level China reached in 2010.
  • The world’s biggest banks. By the late 1980s, the world’s five biggest commercial banks, by total assets, were Japanese. Here’s how China stacks up now:

The magical model that supercharged growth—for a while

Japan’s and China’s economic miracles were quite similar in structure as well.

Building an economic miracle

After World War II wiped out pretty much all of Japan‘s infrastructure and industry, the government was determined both to rapidly boost Japanese manufacturing capacity, and to do so without relying on foreign investment. The economic model it instituted allowed “the Ministry of Finance and its operating arm, the Bank of Japan… to ensure that the right industries got funding when they needed it,” reported R. Taggart Murphy, professor of business at the University of Tsukuba, in his 1996 book, The Real Price of Japanese Money. Which industries were “right” shifted over time. After building up textile manufacturing in the 1950s, the next wave of priority industries included shipbuilding, steel, machine tools, cars, semiconductors, consumer electronics and other sectors geared to export.

After 1978, Deng Xiaoping began introducing market reforms, moving China away from its socialist command-economy roots. Trade opened up, gradually allowing China to exploit its comparative advantage in labor-intensive manufacturing. Until the 2000s, China’s leaders pursued goals of rapid industrialization largely by setting growth and investment targets upon which local officials were evaluated for promotion. Starting in the mid-2000s, however, the central government adopted a Japan-style industrial policy (pdf, p.3) of investing in specific “pillar” or “strategic” sectors, such as steel, shipbuilding and others that Japan too had prioritized.

Industry—particularly manufacturing—that’s “bottle-fed” by banks

The key to managing where money went and when lay in the fact that Japanese bureaucrats—not markets—set the price of money. How? Financial services were concentrated almost entirely in the banks, under the control of the Ministry of Finance, which used them as instruments of industrial policy. The Bank of Japan controlled lending and deposit rates, regardless of supply and demand for capital, effectively forcing savers to subsidize borrowers. Savers and businesses had to accept those rates; there was nowhere else to put their yen.

Despite opening up stock and bond markets throughout the last two decades, China‘s financial system is to this day dominated by state-owned banks required to lend to policy projects and state companies. China’s central bank, the People’s Bank of China (PBoC), still sets deposit rates artificially low, shifting wealth from households and solvent businesses to borrowers. The banking sector remains among one of the most protected and state-dominated in China’s entire economy. Like Japan, it also has several policy banks” that finance the central government projects and development objectives.

Relationship banking

Japanese banking retained this nation-building approach toward lending, each bank forming stable, long-term relationships with a suite of customer companies—what’s called the “main bank” tradition. Credit analysis, therefore, wasn’t necessary. And because government-set interest rates made things incredibly profitable for banks, they loaned like crazy. By the late 1980s, the world’s five biggest commercial banks, by total assets, were Japanese.

As for China, local government leaders still have cozy relationships with branch directors of state-owned banks, as do heads of state-owned enterprises (SOEs). And since they’re a part of the same political apparatus—the Communist Party—they share incentives, such as an interest in keeping credit flowing to GDP-boosting projects. The knit-together political fortunes of local Party officials and bank directors means risk is sidelined in a similar way as it was in Japan.

Weak currency

Besides cheap, plentiful capital, the other thing you need to engineer export-led growth is competitive pricing. Japan did this by making the yen 30% cheaper than it should have been, despite loosening the fixed-dollar exchange rate in the 1970s.

China‘s exports exploded after 1994, when the government adopted a US-dollar peg that cheapened the yuan by 44% against the dollar, versus the previous year. Though it loosened that peg in 2005, letting the yuan appreciate 35% against the dollar, many believe it’s still 5-10% cheaper than it should be. Because China still controls the yuan’s value, no one knows what it’s really worth.

Investment-led growth spurs exports

The rapid capacity expansion that resulted from cheap credit left Japan manufacturing way more goods than domestic demand could support—so Japan exported. And with the government rigging things so it was unusually cheap to manufacture, Japan’s exports were cheaper than their competitors overseas, allowing them gobble up market share. So while Japan’s strategy is frequently called an “export-led” growth model, it’s more accurately described as a”investment-led,” since exporting is the necessary consequence of state-funded overproduction.

China‘s export boom was also in large part courtesy of this investment growth model, which boosted industrial profits at the expense of savers, particularly households, and poured out its production surpluses onto overseas markets.

Low household consumption—and saving like crazy

While Japanese banks paid next to nothing in interest, the cheap yen curbed the purchasing power of households and small businesses. On top of that, the government tightly controlled how much money could leave the country. The less wealthy you feel, the more you save—and the greater the share of investment as a driver of GDP growth.

The situation today in China is much the same. With household consumption at 36% of GDP—the lowest of any major economy—spending is growing more slowly than GDP.

Unwavering faith in the bureaucrats

By the 1990s, the remarkable success of Japan‘s economic growth model inspired confidence among both Japanese and foreigners that “Japan is different.” Many took the fact that the government had allowed no Japanese bank to fail since 1945 as a sign of strength. Because housing prices had risen every year except one since World War II, few believed they could fall. Finally, most people in and out of Japan accepted that superior government management, rather than ultra-low borrowing costs, was responsible for Japan’s industrial resilience. Underlying all these notions was the assumption that the government ultimately guaranteed loans.

Now it’s China that’s so often said to be “different.” Skeptics who argue it won’t be able to wind down its liquidity-fueled investment boom without a credit crisis are often met with the retort that no one’s ever made money betting against the Chinese government. It’s widely believed that the country’s foreign reserves and its bureaucrats’ administrative precision will prevent a banking crisis, as they did on a smaller scale in the late 1990s. Until very recently, many Chinese households assumed that housing prices always go up. And though public defaults are beginning to happen, the government is thought to backstop bad loans that concern any company of consequence.

Bubble trouble

The above model is great while it lasts, but the easy growth it promises has to give out sometime.

For Japan, that happened in the mid-1980s. A strengthening yen against the dollar threatened the country with a recession while simultaneously upping the pressure on the government to reform its financial system, swapping the remaining vestiges of central planning for a true market economy. Not coincidentally, that’s the juncture at which Chinese leaders find themselves now. In both cases, certain events triggered the boom:

The Plaza Accord (Japan) and the global financial crisis (China)

Worried that dollar strength was hurting American manufacturing, US leaders pushed for and finally succeeded in getting Japan to allow the yen to strengthen against the dollar—a product of the 1985 Plaza Accord. The yen’s value surged 100% against the dollar between 1985 and 1988, swallowing up export competitiveness. However, since exporting was “national policy,” as Taggart Murphy reports, exporters clung to market share and cut costs in Japan, causing growth to slump.

As for China, the big blowout there was the global financial crisis in 2008. Though China had to some degree pre-empted problems by gradually strengthening the yuan starting in 2005, it still faced a similar blow to its export sector when the global financial crisis hit.

Cheap credit fuels an investment binge

To brace against the recession that resulted from the surging yen, Japan slashed the discount rate from 5% in January 1986 to 2.5% by February 1987. As cheap credit flooded the economy, an investment frenzy ensued—the deliberate product of the Ministry of Finance policy to cheapen financing costs for Japan’s industrial companies by inflating asset prices, argues Murphy.

With the global recession looming, the Chinese government lowered rates, slashed bank reserve requirements, and launched a 4-trillion-yuan ($586 billion) stimulus, mostly funded by bank credit. The stimulus in large part went to big GDP-driving projects—things like infrastructure and real-estate development. That lending binge has continued: Financing is still growing by around 16% a year, five years after the crisis hit. Last year, investment still contributed half of China’s GDP.

Speculation begets speculation

The Japanese government made it hard for most individuals and smaller businesses to invest overseas. With nowhere else to put it, they pumped their money into Japan’s stock and property markets instead, driving prices up.

As stocks took off, companies clambered aboard; issuing new shares, after all, was much cheaper than paying a bank 5% for a loan. In fact, between 1985 and 1990, Japanese companies raised ¥85 trillion ($638 billion at the time) in capital through the stock market, reports journalist Christopher Wood in his book The Bubble Economy. Most didn’t need the money, though, so instead of expanding their businesses, they sank their new capital into other companies’ shares or into property, further fueling the bubble in stock and property prices. They then got to count the proceeds as corporate profits—driving stock prices even higher.

Though China’s stock market bubble popped in 2007, similar forces are at play in its housing market, where prices in some cities have more than doubled in just a couple of years. In addition to panicked individuals who believe housing prices will only go up, investors include Chinese corporates, many of whose real-estate investments are thought to flatter their profits while their core businesses wither. Meanwhile, Chinese banks own sizable chunks of the corporate debt that they underwrite.

The hidden real-estate risk

Housing bubbles seldom end without a banking crisis. But with some 80% of bank lending directly or indirectly tied up in real estate, as Wood estimates, Japan’s real-estate market compounded its financial crisis even more than usual. China’s lending habits share some alarming traits, including that, says Silvercrest’s Chovanec, notably that property is the “lynchpin” of the Chinese economy, underwriting much of the credit in the system.

Banks issue loans off inflated property values

Japanese banks had traditionally loaned against the value of assets, not the income those assets generated; a property deed was considered the most reliable collateral, explains Wood. That policy came in handy as Japan’s capital markets took off. With big companies relying more on the stock market for funding, banks had to find new customers: smaller companies. Less familiar with these new firms, banks used property as collateral for credit. Soaring property values invited bigger and bigger loans. But because property prices had gone up every year since the end of World War II, banks thought their loans were safe.

In China’s case, banks have been issuing loans off not only inflated, but often falsified property values. For real-estate developers and underground bankers, offering real estate as collateral for new loans is a regular practice, says Victor Shih, professor at University of California, San Diego, and an expert on China’s political economy. But “the method of evaluating the collateral is highly convoluted in China so that collaterals are often valued much higher than market-clearing prices,” Shih told Quartz. “As long as banks and other lenders accept such fictional collateral value, they will continue to lend to distressed borrowers.”

That credit goes… back into property

The money from many of the loans that Japanese banks issued using property as collateral was, in its turn, used to finance still more property development. Exacerbating this cycle was the fact that surging prices had lured many non-property companies into the sector. That meant a sharp drop in property prices would have a much worse impact.

In China today, one-fifth of all outstanding loans are property loans, up from 14% in 2005, according to Nomura. This is likely to grow further, since property lending accounts for 26% of all new loans. Companies involved in China’s $4.8-trillion shadow bank industry—meaning institutions that issue credit off bank balance sheets—are even likelier to involve property as collateral.

And even more credit comes from a shadowy non-bank finance system

On top of all this, Japan had a jusen problem. The jusen were non-bank financial companies that banks had initially founded and financed in the early 1970s to issue mortgages. During the 1980s, they branched out into loaning money from banks to clients engaged in risky real-estate projects, many of which their “parent” banks introduced them to. This was a problem not only because they because the jusen were poorly regulated, but because it was unclear who ultimately guaranteed their shady loans.

One notable parallel in China is its “trust companies”—asset-management companies that play a huge role in shadow finance. Unlike jusen, they loan to a range of industries. However, real estate is among the most popular; as of March, 10% of outstanding trust loans were to property projects, according to David Cui, a strategist at Bank of America/Merrill Lynch. This year, some 634 billion yuan in property trust loans come due (paywall), 50% more than in 2013.

Japanese lessons

Though China’s stock bubble burst back in 2007, it very likely has a housing bubble to contend with. What happens if it pops? As we’ll explore below, Japan’s experience reveals that this depends very much on how the government responds—whether it clings to its old credit-crazy model in an effort to ward off economic collapse, or whether it pushes forward with financial restructuring, allowing some big banks and companies to fail.

The crash and the bad-loan hangover

The end for Japan came in a spectacular slow-motion train wreck. By the end of 1989, Japanese stocks were worth half the world’s entire stock-market capitalization (as Gillian Tett explains in her book, Saving the Sun), and its real estate accounted for about half of all the land value on the planet (according to Peter Hartcher’s 1997 book, The Ministry). Hoping to cool prices, the BoJ yanked up interest rates, anticipating only a slight correction.

Instead the stock market began an inexorable slide. Two years and several rate hikes later, the property market finally followed suit. Japanese companies pulled money back from overseas to patch up their investments at home, and the yen surged, killing exports. The jusen began collapsing in 1995, followed by banks in 1997. When Japan finally emerged from its multi-year financial crisis, in the mid-2000s, seven banks had been nationalized. A conservative estimate of the total cost to taxpayers is at least 20% of Japan’s 2004 GDP (pdf).

But though the crash had begun in 1990, Japan’s bad debts peaked only in 2002, at 35% of total loans. One reason it took so long was that banks lied about how much bad debt they had: In the early 2000s they under-reported the volume of non-performing loans by as much as 37% (pdf, p.6). Plus, the government was largely oblivious to the severity of the non-performing loans problem, says Takeo Hoshi, finance professor at Stanford University. “The general impression was that [bad loans] would hurt the banking sector,” he tells Quartz, “but the sector as a whole had a huge amount of capital, so they could take the loss.”

This wasn’t the only flawed assumption. The other biggie was the persistent, widely held notion that the Japanese economy was on the cusp of recovery, and cash would soon start flowing to insolvent companies again.

In retrospect, that might look daffy, but it seemed reasonable at the time. Banks were still lending, the government was running deficits of around 6% of GDP, and the BoJ was keeping rates next to zero. The government kept issuing optimistic growth forecasts… and kept being proved wrong:

(Hoshi & Kashyap)

Why, then, is Japan only now starting to show signs of recovery, nearly 15 years later? That remains something of a mystery to this day. One answer put forward by economist Richard Koo is that Japanese companies faced “balance sheet recessions,” meaning that they were so busy paying down debt—and not, as theory argues, maximizing profit—that they didn’t grow their businesses.

But that would explain only why existing firms didn’t grow, says Stanford’s Hoshi. “There should be new companies which are not hampered by the existing debt that create value and contribute to economic growth, which happened too little in Japan,” he says. What kept these new firms from emerging?

Japan’s decade of the living dead

In a word, “zombies.”

The term was originally coined in 1987 to describe US banks kept alive by government bailouts. Hoshi and his colleague Anil Kashyap, of the University of Chicago, expanded it to describe unprofitable—”dead”—companies animated by the sinister force of carte blanche credit. As of the early 2000s, around 30% of Japanese public companies (pdf, p.1,994) in construction, real estate, manufacturing, retail and services were unprofitable, kept alive solely by bank loans, according to their research (see chart below). The worse off the sector, the more bank credit it tended to get.

("Zombie Lending and Depressed Restructuring in Japan," Caballero et al.)

Why did banks keep lending to zombies? For one, the government more or less forced them to, as a way to prevent mass layoffs. As Tett documents in detail, bureaucrats consistently pressured banks to continue to loan handsomely to big, unprofitable companies.

And from a bank’s perspective, cutting off credit to a zombie often meant recognizing billions of yen in losses on previously issued loans. This was a problem not only because it would hurt the bank’s bottom line, but because it would risk wiping out huge chunks of capital provisioned for such losses, risking bank failure. On top of that, doing so would force the company’s other lenders to do the same—exposing the underlying risk of the whole system.

Take, for instance, Sogo—a zombie giant if ever there was one. A slew of banks refinanced the large department store well after it became clear it couldn’t repay its debts, says Tett. When Sogo failed in 2000, those debts totaled ¥1.9 trillion. And that failure happened only because one bank finally put its foot down.

By keeping zombies like Sogo on life support, banks did two devastating things. First, they prevented that money from funding new, productive companies. Worse, they effectively subsidized those potentially productive companies’ competitors—i.e., the zombies—by allowing them to keep prices low and wages high. Sogo, until it failed, was basically enjoying a ¥1.9 trillion subsidy. Under such conditions, new companies couldn’t compete.

This also explains why Japan’s bad loan problem got so inconceivably huge. “By recycling loans, banks essentially doubled and tripled their bets on these zombie firms,” Kashyap says. “If banks had cut their losses back in 1994 rather than consciously ignoring the problem until 1997, the situation would not have been nearly as bad.”

(Morgan Stanley)

Signs that China’s zombie apocalypse is nigh

With China’s stock market already mired in its epic slump, the thing most likely to trigger a Japan-style crisis is a real estate market collapse. However, China already exhibits more than a few symptoms of a zombie infection. Even without the catalyst of a market crash, it in many ways already seems more like Japan in the late 1990s than the Japan of 1989.

Though lending continues to surge, it’s getting harder and harder for China to grow. In 2013, credit rose 10% annually (paywall), much higher than the 7.5% expansion of official GDP. That trend is worsening: China must invest twice what it did in 2008 to generate the same amount of GDP growth, according to Wei Yao, an economist at Société Générale. By her tally, China now owes the equivalent of 38.6% of its GDP in principal and interest each year.

(Société Générale)

But growth won’t revive until credit starts supporting the right businesses or industries. Even though state-owned enterprises (SOEs) tend to be much less profitable than private firms, the big banks are also state-owned. And because China’s credit system is still based on political, and not market, risk, the big state-owned banks still loan to SOEs over smaller companies.

That system, says Hoshi, looks awfully familiar. “In a similar way that the Japanese [lending practices] discouraged new entrants… Chinese SOEs are doing the same thing,” he says. “They’re protected, they’re not that profitable, but they can stay in the market because they’re owned by the state, which reduces the possible profit of new entrants.”

Is that keeping potentially profitable businesses from getting market share? Leland Miller, head of research firm China Beige Book, thinks so. The “share of bank loans funding expansion as opposed to debt rollovers is near an all-time low,” says Miller. “What’s happening here is that despite massive credit expansion for years, an increasingly small share of that capital is making its way to firms on the ground, particularly small- and medium-sized companies.”

("Fixing China's State Sector," Andrew Batson)

How do you stop a zombie invasion?

It might seem as if the moral of Japan’s tragic tale is simply that after an investment binge, it’s vital to give money to good companies and let the bad ones die. But it’s not that simple. After all, “good” and “bad” differ depending on which economic model you’re trying to promote.

That was exactly Japan’s problem. For two decades starting in the mid-1980s, it was caught straddling two models—one government-managed, the other market-oriented, each with different definitions of which companies were “good.” In this accidental hybrid, the mechanisms that limited risk and delivered growth often cancelled each other out. As Japan dithered on financial reform, it created still more bad loans and throttled the emergence of vibrant new companies that could power growth. That procrastination would prove enormously expensive for the Japanese people.

China is in a similar boat. And Japan’s experience explains why the challenges facing the Chinese economy are actually much greater even than avoiding a housing market crash or a financial crisis. China’s leaders may well be able to steer the country clear of either. But pulling off yet another miracle of administrative legerdemain will be perilous if it means China’s leaders further postpone financial reforms—things like lifting the deposit-rate cap, allowing SOE failures, or permitting foreign banks to compete. One thing Japan’s history makes painfully vivid is that the longer China waits, the larger its zombie horde grows.

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