Saturday, 3 December 2022

Nomura’s Koo: “China may be facing a balance sheet recession, but it can withstand with strong fiscal stimulus”

5 min read

Interviewed By The Asian Banker Live

Richard Koo, chief economist of Nomura Research Institute discussed the property bubble in China and compared it with Japan’s experience in 1992. He also cited US’ experience during the Great Depression in 1929. He analysed the causes of property bursts in China and Japan and the importance of fiscal stimulus from the government to avert recession.

China, with a gross domestic product (GDP) per capita of $12,000, is not any more the lowest-cost producer. Countries like Bangladesh, the Philippines and Indonesia are on the lookout for factories flying out of China.

He also tackled the balance sheet recession, which was coined long after Japan’s property bubble. He then wrote a book, which is now being read by many to deal with the balance sheet recession.  Koo is the author of “Pursued Economy,” a book that covered some of the issues he discussed.

The edited transcript of the speech:

Hello, this is Richard Koo, joining you from Tokyo, Japan. I'm the chief economist of Nomura Research Institute. I understand that the previous speakers have spoken quite a bit about the global economy covering all the possible growth forecasts.

For my presentation, I just want to concentrate on two countries, China and Japan, or Japan 30 years ago, because I understand that there are quite a few people in China wondering with the bursting of the real estate bubble, would China end up repeating what happened to Japan? I lived through the entire period of Japan during the bubble days and afterwards and I spent quite a bit of my time analysing what actually happened to Japan and why. So, I'd like to share some of those thoughts with you on this presentation.

This chart shows what actually happened to Japan, the gross domestic product (GDP) and what happened to Japan's commercial real estate. In the Japanese bubble, it was the commercial real estate that led the bubble. In the Chinese bubble, I understand, it's the housing prices. But, in the Japanese case, it was commercial real estate, and if you see that, it (the purple line) went up very sharply. This purple line went up like five times in five years. And it came crashing down, fell to the level of 1973, down 87% from the peak. Just think about what this 87%. It's not just a little corner of Tokyo or Osaka, it’s the entire country. So, it's like prices falling 87% in Beijing, Shanghai, Hangzhou, Guangzhou, Shenzhen, all down 87%. And what kind of economy do you think you'll get left in China if that happens?

Then you look at what happened to Japanese GDP both in nominal and real terms. It slowed down quite dramatically, but it actually never fell below the peak of the bubble. It was always about the peak of the bubble. And that was because Japanese government came in and supported the economy, even though the private sector was having huge balance sheet problems after asset prices collapsed, liabilities remained in the balance sheets, all fell under water.

Here's another little line here that shows what happened to US’ GDP during the Great Depression. Great Depression was also this kind of recession. And US loss wealth equivalent to one year's worth of 1929 GDP due to what happened, as the prices, and lost 46% of its GDP. Japan lost wealth three times larger than the American’s loss during the Great Depression, because Japan lost wealth equivalent to three years’ worth of 1989 GDP. But Japanese GDP did not fall 46%. It actually stayed above. So, I would like to explain how that was done.

But if I may compare this with what's happening to China, this chart shows what happened to Tokyo and Osaka prices back then and what has happened to Beijing house prices recently. And even though the shapes and the patterns are a little bit different, the Chinese price increases are nearing what happened to Japan. And even though we don't have good data on how the prices may be falling in China, because I understand that some of those transactions are actually stopped by the government, if you want to try to sell it at too lower price. But in terms of the magnitude of the bubble, it is coming closer to what Japan experienced 30 years ago.

So, this part of chart explains why the Japanese GDP never fell below the peak of the bubble. Now let me explain how this chart is put together. There are four lines here, corporate line, household line, government line and the rest of the world line. And if you add all these four lines together, you're supposed to get zero. And the way it is put together is that there's a horizontal line across zero. Above zero is other people saving money, financial surplus. Below zero is the people borrowing money, financial deficit. As I said earlier, these four lines are supposed to add up to zero. And when you look at this, you'll notice that it was the Japanese corporations that heavy blue line that was borrowing massively during the bubble days. They borrow as much as 12% of GDP, going crazy with investments in all sorts of assets. Then, once the bubble burst, you see this blue line going sharply higher. So that means they were reducing their borrowings. By 1999, the line is actually above zero. Above zero means the entire corporate sector is actually paying down debt and saving money instead of borrowing. We all were told that in the household sector is supposed to save and corporate sector is supposed to borrow. But we had a situation where both household sector and corporate sector were actually savers.

And by 2003, corporate sector was above the household sector. So the biggest saver was the corporate sector, no longer the household sector. Now, this is a huge problem, because in a national economy, if someone is saving money, someone else has to borrow money to keep the economy going. And usually, it's the adjustments in interest rate that makes this possible. But we had a situation in Japan after 1997 or so where both corporate sector and household sector were saving at by then zero interest rates. And so the only way to keep this economy going was to allow the government to borrow money. And as you can see on this green line, government did the opposite of the corporate sector. And that allowed the Japanese economy to keep its GDP from falling. So when you are in this type of recession, the most important thing is fiscal stimulus, government borrowing and spending money. Because if that is not done, you end up with what you saw earlier, with the US GDP falling 46%, after the bursting of the bubble in 1929.

Now, so where does China stand on this? This is from the China's flow of funds data. And I noticed that the Chinese corporate sector actually has been reducing their borrowings quite substantially since around 2015, long before the bubble burst. So while the bubble was going on, Chinese corporate sector was actually reducing their borrowings. And if the corporate sector is reducing their borrowings, but household sector is still saving money, the economy would have collapsed. But then the government, the green line, kept on borrowing money to offset what was happening to the corporate sector even before the bubble burst. This only goes up to 2020. So 2021, now 2022, these numbers are likely to have diverged even further. Our chances are high that Chinese corporate sector borrowed even less, maybe becoming a big net saver by now. And that means the government will have to borrow more to offset the deflationary impact coming from that source.

Now, in the Japanese case, when this bubble burst, no one knew that we have this disease called “Balance Sheet recession”. I mean, I came up with this whole concept around 1997. And now it's understood all around the world. But in 1990, no one knew about this process of balance sheet recession, where once the bubble burst, as the price collapse, liabilities remain, all these people will start repairing their balance sheets by paying down debt. That's the right thing to do for the households and the companies to repair their balance sheets. But, when everybody does it all at the same time, there will be no one borrowing money. No one is borrowing money that households and companies are saving, then the economy collapses. Well, this was never explained in economic textbooks until I start talking about it. And so Japan wasted a lot of time talking about structural reforms, more monetary stimulus. It last like seven, eight years before they really realised that, ‘oh my gosh, we really needed the fiscal stimulus’.

In the Chinese case, I understand that most people are fully aware of this balance sheet recession. This is the book that I wrote many years ago. And I understand that a lot of people are reading it even now. And so my guess is that Chinese government will put in the fiscal stimulus quickly enough to make sure that the recession will not last any longer than necessary. But it will still take a long time for the private sector to really repair their balance sheets. And during the whole period, government has to keep this fiscal stimulus in place just to make sure that the economy will not fall into a deflationary spiral.

Now, so in that sense, because Chinese officials probably are aware of this disease called balance sheet recession and know how to fix it, how to fight that actually, that's a good positive for China. But unfortunately, not everything is positive for China.

This shows the share of construction industry in China relative to Japan and the US. Why is this important? Well, when the Japanese bubble burst back in 1990, it was really a bubble. There was very little construction going on at that time. So how's the real estate prices went high and it came crashing down, but it wasn't that much pickup in construction during that period. At that time, if you look at this chart around 1990, there was a bit of an increase in construction, as you can see, but it's nothing to write home about. And at that time, Japan's construction industry was about 20% of Japan's GDP. In the Chinese case, however, look how much increase in construction that took place prior to the bubble. It increased quite dramatically. And that is actually a good thing for human welfare, for economic welfare. It’s not the land that matters, it's the floor space. And the fact that Chinese bubble, if you can call it that, was accompanied by huge construction boom, I think is a good thing, not a bad thing. Because as you get more floor space, people have bigger places to live, and that adds to the Chinese people's welfare. So I was very encouraged to see that there was so much construction during this period, unlike the Japanese one, where the prices went up, everybody went crazy, and prices came down, people just left with a debt. No floor space to show for. But the fact that now the construction industry in China is in very big difficulty and many of these constructions have stopped, that means that will hit the Chinese GDP, the way the Japanese GDP was never affected, because Japanese GDP was not all that dependent on construction at that point. But the Chinese GDP or economic activity in general is very much dependent on construction. Up to this point, 26% of the Chinese GDP is actually construction industry. So when this thing starts falling, I'm afraid that will affect the GDP unlike the way it affected Japan. Japan, it was just a balance sheet problem. In the Chinese case is both the balance sheet problem and the weakness in the construction industry. So if I were Chinese official, if I were in charge of Chinese economic policy, I will make sure that all the construction project that was started by the private sector construction developers will be finished with the fiscal help from the government. I think that will be the best and the most efficient way to use your fiscal policy in the short run, because with a little bit of help with these constructions restarted, that will keep the Chinese GDP from falling. And at the end of the day, you have all the floor spaces where the Chinese people do live. So that's the construction part.

But also there are a few other issues that Japanese never had to worry about back then, which the Chinese people have to worry about this time around.

Here, I listed the kind of challenges that Japan faced back in 1990, and what China may be facing in 2022. The Japanese bubble, of course, was huge. And after the Japanese bubble burst, we have a huge balance sheet recession that lasted nearly 15 years. It didn't have to last 15 years if the government knew it had to do, but we didn't know how to react to this balance sheet recession because it was never on economic textbooks. So, they wasted a lot of time, the first 10 years or so, and only got their act together much later.

At the same time, Japan was facing this trade friction with United States. Japan alone accounted for something like 60% of the US trade deficit, one country. I mean, China today accounts around 35% of the US trade deficit where 65% are other countries. But in the Japanese case, Japan alone, one country, was like 60% of US trade deficit, and naturally, there was a lot of frictions. But nothing like trade war that we are facing now after President Trump in the United States. So those two are the issues that Japan had to face.

But in the Chinese case, as I said earlier, there's a balance sheet recession that we have to deal with, and a construction recession that you also have to deal with. But these two can be handled with the same fiscal stimulus. If the fiscal stimulus is used to help finish all the private sector projects. Then, that will be killing both birds with one stone - balancing recession and the construction recession. However, China is also facing this geopolitical confrontation with the West. This could get quite ugly going forward, especially with all these other geopolitical tensions happening in Ukraine, and so forth. China is also facing population decline. All of us thought, and I'm sure many people in China also thought that population in China will start declining maybe around 2030 and beyond. I use that to do my economic forecast. But we all discovered that maybe population actually peaked last year. This year, it may already be declined. If that is true, then China will be facing both the balance sheet recession and population decline at the same time.

Whereas in the Japanese case, the population decline came 19 years after the bursting of the bubble. After the bursting of the bubble in 1990, population decline actually took place in 2009. So we had 19 years. But in China, the two things are happening at the same time.

And one other point that we need to pay attention is this whole concept of middle-income trap. And I'm sure many Chinese economists are fully aware of this. That is that if you are the lowest cost producer in the world, that country will start attracting factories from all around the world. But once the country is no longer the lowest cost producer and other countries offering cheaper wages and so forth, factories will start moving to those even lower cost countries. That slows down the investment in the country, and that slows down the economic growth. China was the lowest cost producer for many years. That's how China attracts so many factories from around the world. But now, for capita GDP of around $12,000, China is no longer the lowest cost producer. There are many other countries in Southeast Asia, such as Philippines, Bangladesh, Indonesia, they love to get the factories from China. So many Chinese factories, Chinese companies, and foreign companies facing these higher wages in China may be tempted to move their factories abroad. But with that happens, there will be less investment in China, less growth in China. And not too many countries, I'm afraid have actually passed when through the middle-income trap. There are only very few countries, Taiwan, Japan, South Korea and Singapore. Most of the others were stuck in the middle-income trap. And so this is a huge challenge. And policymakers have to make the country continuously attractive, so that both domestic and foreign countries continue to invest inside the country. And that's quite a bit of challenge.

But in spite of that challenge, we have seen some regulatory uncertainty in industries such as real estate, IT and education sectors. I'm afraid those are not very useful, especially when the country is in the middle-income trap. And all of these things, kind of reinforce each other. For example, geopolitical confrontation with the West may prompt people to say, do we really want to keep our factories in China? Shall we move it to somewhere else? And then if there's a middle-income trap consideration too that wages are much cheaper in Bangladesh or in the Philippines, some of these factories may actually start moving to those places and that reduces the economic growth.  For population decline, I mean, a lot of people made a big issue out of population decline on Japan, I can assure you that that is not the biggest problem by itself. If you look at how many people actually employed in Japan, the number of employed in Japan is all time high today. So even though the populations have been declining, the number of people working is at all-time high. It came down a little bit because of COVID, but it's basically staying up there. So population decline by itself will not hurt the economy. But this mentality that population is declining reduces the people's incentive to invest in the country on the assumption that the market will be growing, while markets will not be growing all that fast so that will discourage investments.

So, all of these things that are happening in China is adding to the problem of balance sheet recession. If I were Chinese policymaker, I'm sure that Chinese policymakers can handle balance sheet recession and construction recession. But the other one that Japan never had to face 30 years ago, they may be a big challenge for Chinese policymakers forward. And I hope policymakers in China will take these very seriously and take appropriate actions because it's too early for China to slow down. I mean Chinese people are still willing to work so hard, Chinese students are willing to study so hard. So there's still a lot of potential in the country. But if we don't address these issues that I mentioned here, the economy could slow down, in my view prematurely. Some of these issues that I mentioned are actually covered in my latest book Pursued Economy where I do cover many of these issues that I mentioned. This book just came out about three weeks ago. I hope the Chinese version will follow at some point. Yes, China may be facing a balance sheet recession, but I think China can handle it, especially with strong fiscal stimulus. But all the other factors that China has to face are going to be not easy. And I hope policymakers will address them carefully and thoroughly. Thank you very much. 


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