Not just another fake

Illustration by Derek Bacon

Correction to this article

CHINA rebounded more swiftly from the global downturn than any other big economy, thanks largely to its enormous monetary and fiscal stimulus. In the year to the fourth quarter of 2009, its real GDP is estimated to have grown by more than 10%. But many sceptics claim that its recovery is built on wobbly foundations. Indeed, they say, China now looks ominously like Japan in the late 1980s before its bubble burst and two lost decades of sluggish growth began. Worse, were China to falter now, while the recovery in rich countries is still fragile, it would be a severe blow not just at home but to the whole of the world economy.

On the face of it, the similarities between China today and bubble-era Japan are worrying. Extraordinarily high saving and an undervalued exchange rate have fuelled rapid export-led growth and the world's biggest current-account surplus. Chronic overinvestment has, it is argued, resulted in vast excess capacity and falling returns on capital. A flood of bank lending threatens a future surge in bad loans, while markets for shares and property look dangerously frothy.

Just as in the late 1980s, when Japan's economy was tipped to overtake America's, China's strong rebound has led many to proclaim that it will become number one sooner than expected. In contrast, a recent flurry of bearish reports warn that China's economy could soon implode. James Chanos, a hedge-fund investor (and one of the first analysts to spot that Enron's profits were pure fiction), says that China is “Dubai times 1,000, or worse”. Another hedge fund, Pivot Capital Management, argues that the chances of a hard landing, with a slump in capital spending and a banking crisis, are increasing.

Scary stuff. However, a close inspection of pessimists' three main concerns—overvalued asset prices, overinvestment and excessive bank lending—suggests that China's economy is more robust than they think. Start with asset markets. Chinese share prices are nowhere near as giddy as Japan's were in the late 1980s. In 1989 Tokyo's stockmarket had a price-earnings ratio of almost 70; today's figure for Shanghai A shares is 28, well below its long-run average of 37. Granted, prices jumped by 80% last year, but markets in other large emerging economies went up even more: Brazil, India and Russia rose by an average of 120% in dollar terms. And Chinese profits have rebounded faster than those elsewhere. In the three months to November, industrial profits were 70% higher than a year before.

China's property market is certainly hot. Prices of new apartments in Beijing and Shanghai leapt by 50-60% during 2009. Some lavish projects have much in common with those in Dubai—notably “The World”, a luxury development in Tianjin, 120km (75 miles) from Beijing, in which homes will be arranged as a map of the world, along with the world's biggest indoor ski slope and a seven-star hotel.

Average home prices nationally, however, cannot yet be called a bubble. On January 14th the National Development and Reform Commission reported that average prices in 70 cities had climbed by 8% in the year to December, the fastest pace for 18 months; other measures suggest a bigger rise. But this followed a fall in prices in 2008. By most measures average prices have fallen relative to incomes in the past decade (see chart 1).

The most cited evidence of a bubble—and hence of impending collapse—is the ratio of average home prices to average annual household incomes. This is almost ten in China; in most developed economies it is only four or five. However, Tao Wang, an economist at UBS, argues that this rich-world yardstick is misleading. Chinese homebuyers do not have average incomes but come largely from the richest 20-30% of the urban population. Using this group's average income, the ratio falls to rich-world levels. In Japan the price-income ratio hit 18 in 1990, obliging some buyers to take out 100-year mortgages.

Furthermore, Chinese homes carry much less debt than Japanese properties did 20 years ago. One-quarter of Chinese buyers pay cash. The average mortgage covers only about half of a property's value. Owner-occupiers must make a minimum deposit of 20%, investors one of 40%. Chinese households' total debt stands at only 35% of their disposable income, compared with 130% in Japan in 1990.

China's property boom is being financed mainly by saving, not bank lending. According to Yan Wang, an economist at BCA Research, a Canadian firm, only about one-fifth of the cost of new construction (commercial and residential) is financed by bank lending. Loans to homebuyers and property developers account for only 17% of Chinese banks' total, against 56% for American banks. A bubble pumped up by saving is much less dangerous than one fuelled by credit. When the market begins to crack, highly leveraged speculators are forced to sell, pushing prices lower, which causes more borrowers to default.

Even if China does not (yet) have a credit-fuelled housing bubble, the fact that property prices in Beijing and Shanghai are beyond the reach of most ordinary people is a serious social problem. The government has not kept its promise to build more low-cost housing, and it is clearly worried about rising prices. In an attempt to thwart speculators, it has reimposed a sales tax on homes sold within five years, has tightened the stricter rules on mortgages for investment properties and is trying to crack down on illegal flows of foreign capital into the property market. The government does not want to come down too hard, as it did in 2007 by cutting off credit, because it needs a lively property sector to support economic recovery. But if it does not tighten policy soon, a full-blown bubble is likely to inflate.

The world's capital

China's second apparent point of similarity to Japan is overinvestment. Total fixed investment jumped to an estimated 47% of GDP last year—ten points more than in Japan at its peak. Chinese investment is certainly high: in most developed countries it accounts for around 20% of GDP. But you cannot infer waste from a high investment ratio alone. It is hard to argue that China has added too much to its capital stock when, per person, it has only about 5% of what America or Japan has. China does have excess capacity in some industries, such as steel and cement. But across the economy as a whole, concerns about overinvestment tend to be exaggerated.

Pivot Capital Management points to China's incremental capital-output ratio (ICOR), which is calculated as annual investment divided by the annual increase in GDP, as evidence of the collapsing efficiency of investment. Pivot argues that in 2009 China's ICOR was more than double its average in the 1980s and 1990s, implying that it required much more investment to generate an additional unit of output. However, it is misleading to look at the ICOR for a single year. With slower GDP growth, because of a collapse in global demand, the ICOR rose sharply everywhere. The return to investment in terms of growth over a longer period is more informative. Measuring this way, BCA Research finds no significant increase in China's ICOR over the past three decades.

Mr Chanos has drawn parallels between China and the huge misallocation of resources in the Soviet Union, arguing that China is heading the same way. The best measure of efficiency is total factor productivity (TFP), the increase in output not directly accounted for by extra inputs of capital and labour. If China were as wasteful as Mr Chanos contends, its TFP growth would be negative, as the Soviet Union's was. Yet over the past two decades China has enjoyed the fastest growth in TFP of any country in the world.

Even in industries which clearly do have excess capacity, China's critics overstate their case. A recent report by the European Union Chamber of Commerce in China estimates that in early 2009 the steel industry was operating at only 72% of capacity. That was at the depth of the global downturn. Demand has picked up strongly since then. The report claims that the industry's overcapacity is illustrated by “a startling figure”: in 2008, China's output of steel per person was higher than America's. So what? At China's stage of industrialisation it should use a lot of steel. A more relevant yardstick is the America of the early 20th century. According to Ms Wang of UBS, China's steel capacity of almost 0.5 tonnes per person is slightly lower than America's output in 1920 (0.6 tonnes) and far below Japan's peak of 1.1 tonnes in 1973.

Many commentators complain that China's capital-spending spree last year has merely exacerbated its industrial overcapacity. However, the boom was driven mainly by infrastructure investment, whereas investment in manufacturing slowed quite sharply (see chart 2). Given the scale of the spending, some money is sure to have been wasted, but by and large, investment in roads, railways and the electricity grid will help China sustain its growth in the years ahead.

Some analysts disagree. Pivot, for instance, argues that China's infrastructure has already reached an advanced level. It has six of the world's ten longest bridges and it boasts the world's fastest train; there is little room for further productive investment. That is nonsense. A country in which two-fifths of villages lack a paved road to the nearest market town still has plenty of scope for building roads. The same goes for railways. Again, a comparison of China today with the America of a century ago is pertinent. China has roughly the same land area as America, but 13 times more people than the United States did then. Yet on current plans it will have only 110,000km of railway by 2012, compared with more than 400,000km in America in 1916. Unlike Japan, which built “bridges to nowhere” to prop up its economy, China needs better infrastructure.

It is true that in the short term, the revenue from some infrastructure projects may not be enough to service debts, so the government will have to cover losses. But in the long term such projects should lift productivity across the economy. During Britain's railway mania in the mid-19th century, few railways made a decent financial return, but they brought huge long-term economic benefits.

The biggest cause for worry about China is the third point of similarity to Japan: the recent tidal wave of bank lending. Total credit jumped by more than 30% last year. Even assuming that this slows to less than 20% this year, as the government has hinted, total credit outstanding could hit 135% of GDP by December. The authorities are perturbed. This week they increased banks' reserve requirement ratio by half a percentage point. They have also raised the yield on central-bank bills.

However, too many commentators talk as if Chinese banks have been on a lending binge for years. Instead, the spurt in 2009, which was engineered by the government to revive the economy, followed several years in which credit grew more slowly than GDP (see chart 3). Michael Buchanan, of Goldman Sachs, estimates that since 2004 China's excess credit (the gap between the growth rates of credit and nominal GDP) has risen by less than in most developed economies.

Even so, recent lending has been excessive; combined with overcapacity in some industries, it is likely to cause an increase in banks' non-performing loans. Ms Wang calculates that if 20% of all new lending last year and another 10% of this year's lending turned bad, this would create new bad loans equivalent to 5.5% of GDP by 2012, on top of 2% now. That is far from trivial, but well below the 40% of GDP that bad loans amounted to in the late 1990s.

Much of the past year's bank lending should really be viewed as a form of fiscal stimulus. Infrastructure projects that have little hope of repaying loans will end up back on the government's books. It would have been much better if such projects had been financed more transparently through the government's budget, but the important question is whether the state can afford to cover the losses.

Official gross government debt is less than 20% of GDP, but China bears argue that this is an understatement, because it excludes local-government debt and the bonds issued by the asset-management companies that took over banks' previous non-performing loans. Total government debt could be 50% of GDP. But that is well below the average ratio in rich countries, of around 90%. Moreover, the Chinese government owns lots of assets, for example shares of listed companies which are worth 35% of GDP.

Yin and yang

Even if, as argued above, concerns about a financial crash in China are premature, the risks of a dangerous bubble and excessive investment will clearly increase if credit continues to expand at its recent pace. The stitching on the Chinese economy could fray and burst. Would that imply the end of China's era of rapid growth?

Predictions that China is heading for a prolonged Japanese-style slump ignore big differences between China today and Japan in the late 1980s. Japan was already a mature, developed economy, with a GDP per person close to that of America. China is still a poor, developing country, whose GDP per person is less than one-tenth of America's or Japan's. It has ample room to play catch-up with rich economies by adding to its capital stock, importing foreign technology and boosting productivity by shifting labour from farms to factories. This would make it easier for China to recover from the bursting of a bubble.

Chart 4 examines the relationship between growth rates and income per head for six Asian economies. Each plot shows a country's growth rate and GDP per person relative to America's for successive ten-year periods, starting when their rapid growth took off. It illustrates how growth rates slow as economies catch up with America, the technological leader. The fact that China's GDP per head is much lower than Japan's in the 1980s suggests that its growth potential over the next decade is much higher. Even though China's labour force will start shrinking after 2016, rapid productivity gains mean that its trend GDP growth rate is still around 8%, down from 10% in the past decade.

Japan's stockmarket and land-price bubbles in the early 1960s offer a better (and more cheerful) analogy to China than the 1980s bubble era does. Japan's economy was poorer then, although relative to America its GDP per person was more than double China's today, and its trend rate of growth was around 9%. According to HSBC, after the bubble burst in 1962-65, Japan's annual growth rate dipped to just under 6%, but then quickly rebounded to 10% for much of the next decade.

South Korea and Taiwan, which experienced big stockmarket bubbles in the 1980s, are also worth examining. In the five years to 1990, Taipei's stockmarket surged by 1,600% (in dollar terms) and Seoul's by 700%, easily beating Tokyo's 450% gain in the same period. After share prices slumped, annual growth in both South Korea and Taiwan slowed to around 6%, but soon regained its previous pace of 7-8%.

The higher a country's potential growth rate, the easier it is for the economy to recover after a bubble bursts, so long as its fiscal and external finances are in reasonable shape. Rapid growth in nominal GDP means that asset prices do not need to fall so far to regain fair value, bad loans are easier to work off and excess capacity can be more quickly absorbed by rising demand. The experience of Japan in the 1960s suggests that if China's bubble bursts, it will hurt growth temporarily but not lead to prolonged stagnation.

However, it is Japan's experience after the 1980s that most influences the thinking of policymakers in Beijing. Many blame Japan's deflation and its lost decades of growth on the fact that its government caved in to American demands for an appreciation of the yen. In 1985 central banks in the big rich economies agreed, in the Plaza Accord, to intervene to push down the dollar. By 1988 the yen had risen by more than 100% against the greenback. One reason why policymakers in Beijing have resisted a big rise in the yuan is that they fear it could send their economy, like Japan's, into a deflationary slump.

The wrong lesson

Illustration by Derek Bacon

Yet Japan's real mistake was not that it allowed the yen to rise, but that it had previously resisted an appreciation for too long, so that when it did happen the yen soared. A second error was that Japan tried to offset the adverse economic effects of a strong yen with over-lax monetary policy. If policy had been tighter, the financial bubble would have been smaller and its aftermath less painful.

This offers two important lessons to China. First, it is better to let the exchange rate rise sooner and more gradually than to risk a much sharper appreciation later. Second, monetary policy should not be too slack. Raising reserve requirements is a small step in the right direction. Despite the bears' growling, China's economic collapse is neither imminent nor inevitable. But if it continues to draw the wrong lesson from the tale of Japan, then one day its economy may look just as tatty.

Correction: We quoted some figures from a UBS report, to the effect that “China's steel capacity of almost 0.5kg per person is slightly lower than America's output in 1920 (0.6kg) and far below Japan's peak of 1.1kg in 1973.” All those figures should have been tonnes, not kilograms. This was corrected on January 18th 2010.