Ichiro Suzuki Nomura Research Institute economist Richard Koo is forever proud of having coined a word ‘balance sheet recession’ to describe monumental downward pressure that hit the Japanese economy in the 1990s and kept plaguing it in early years of the 21st century. It is about an economic downturn caused by shortage of capital in the banking system that constrains growth of credit. In the 1980s, Japanese banks went on a lending spree in a booming economy. Asset prices, of real estate and stocks in particular, surged. Lending to real estate developing was seen as a a license to mint money. It was a great business, of course, until it wasn’t. After having gone as far as they could, real estate prices fell precipitously as the 1990s set in. A significant portion of real estate loans had turned out to be non-performing. Writing down those non-performing loans (NPLs) made a material dent in banks’ balance sheets. Insufficient capital weakened banks’ credit creation capability that in turn exerted downward pressure on the economy. This is a standard process of a banking crisis, and Mr. Koo popularized it as balance sheet recession. The Great Recession of 2007-09 was a quintessential balance sheet recession. Melt-down of the U.S. real estate market made AAA-rated exotic mortgage-backed securities worthless, inflicting huge holes on the capital base of banks. The paralyzed banking system sent the economy in the U.S. and elsewhere into the deepest recession since the early 1930s. A real estate boom always ends in tears. China watched Japan’s ordeal. The Communist Party studied every single steps that the Japanese economy followed in its descent, and vowed to themselves not to let this happen to China. Japan offered China a great lesson to learn from. The problem was very clear. No disciplined minds would repeat that folly, they thought. Determination not to repeat Japan’s monumental policy error, however, did not prove to be enough to keep China away from Japan’s path step by step. In some critical moments over the last 15 years, Beijing made a decision to save the real estate market, succumbing to short-term temptations at the sacrifice of long-term goal of staying away from Japan’s path. The biggest error the CCP had committed was their desperate effort to keep the economy from sinking, in the face of the 2007-09 Great Recession that was caused by the global banking system’s collapse due to implosion of mortgage-related debt securities. The CCP’s effort to save the Chinese economy was heroic amid a sheer dearth of demand in the global economy back then. It saved the world from plunging into a repeat of the 1930s. Temptations to bail out the economy, however, didn’t end there. On every economic downturn since then, the CCP stepped in to boost demand. Credentials of the CCP lies in having lifted hundreds of millions of Chinese people out of poverty since Deng Xiao Ping’s rise to power in the late 1970s. They didn’t afford not to do anything in the face of marked economic slowdowns even if prices they had to pay was accumulation of debt and weakening of the banking system. Having been aware of the prices, they still had to do it nonetheless. Xi Jinping consolidated power to be the most powerful leader since Mao Zedong amid halving of the Chinese economy’s growth rate. He didn’t afford not to keep stimulating the economy as much as possible, to stay on as the unprecedented leader beyond two terms. So here are the prices the CCP paid: Over-investment in the real estate sector, house prices beyond the reach of average Chinese people in large cities, the stretched banking sector loaded with potential non-performing loans whether NPLs are recognized in the same fashion as in the West or not, downward pressure on demand caused by banks’ inability to lend. Welcome to the world of balance sheet recession. It arrives at any place where credit growth has fiercely outstripped genuine demand in the economy, taking the banking sector down with ballooning NPLs, thus sentencing a slow death to the economy, however mighty the ruler might be. The only solution to this problem begins with admitting mistakes and accepting the reality, which are the first steps of writing down the NPLs and recapitalizing bank balance sheets. Doing this would require voting out leaders in elections, in democracy of course. This can’t be done in a land of the almighty ruler. The prices Xi Jinping forces Chinese people to pay, therefore, would be living under sub-par growth as opposed to China’s potential, and mild deflation. It was showcased in the People’s Bank of China’s surprise rate cut last month in response to weaker than expected demand, whereas economies in the developed world have gone through a series of aggressive rate hikes.
About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.
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