Reverse Financial Repression

By Ichiro Suzuki World War II left mounting public sector debt to the countries on both sides. Japan took care of it through ravaging inflation, which effectively wiped out fortunes of government bond holders and depositors. Post-WWI Weimar Germany did it, too, in epic hyperinflation that has a firm place in economic history. The United States took care of debt a little more subtly. In the post-WWII economy, interest rates were kept artificially low, to prevent interest payments from blooming. Financial repression denied the household sector a chance to receive appropriate interest that matched the state of the economy. Nonetheless, they suffered far less damages on their assets than in countries that were ravaged by inflation. In more recent times, the Bank of Japan in the late 1980s and the outset of the 1990s lifted interest rates to draconian levels to crush a real estate bubble, and then let interest rates fall sharply and left them low in order to alleviate the government’s interest rate payment burden on a pile of debt. China is dealing with debt in a different way. Having witnessed doldrums in the Japanese economy in the 1990s and afterward that followed the burst of a real estate bubble, China found it unaffordable to prick high real estate prices. Doing so would materially slow down the growth rate of the economy, throwing out tens of millions of people, especially construction sector workers, onto streets without a job. For fear of economic meltdown, the Chinese Communist Party is managing the real estate sector so as not to let it go down entirely, allowing property prices to stay stable in stead of deflating them, with tacit, unofficial, guarantees on borrowers by the government. The absence of real estate market crush keeps reasonable demand for loans. At the very least, over-stretched borrowers have to keep borrowing to stay afloat. This ‘false’ demand for money contributes to higher interest rates than would otherwise have been the case. Hence, lenders are able to collect interest, and bond holders can receive coupon payments, both of which are kept artificially high. Thus, wealth is transferred to lenders, state-owned banks essentially, from the private sector. This unhealthy process of inappropriate wealth transfer into state-owned banks and other actors in the public sector through giant but weakened borrowers is called ‘reverse financial repression’ by China watcher Toshiya Tsugami, who is a former official with Japan’s Ministry of Economy, Trade and Industry (METI). Mr. Tsugami estimates that bank loans and local government financial vehicles (LGFV) with insufficient cash generation to repay interest own their own amount to over 30% of China’s GDP. In other words, debt whose size is about a third of the economy needs further borrowing in order for the borrowers to make interest payments and just to stay afloat. Even worse, they keep transferring wealth to those who are already wealthy, at the expense of those who are not. While vulnerable real estate developers are allowed to dodge bankruptcy, these borrowers are hardly productive actors in the economy. They are rather zombie companies that should have been long gone in an economy that operates strictly guided by the invisible hand. Loans that zombies receive should have gone to other businesses that wish to expand factories or open a new shop. They do not contribute to economic growth though they do keep the economy from crushing down in the immediate future. China Evergrande is a case in point. The Communist Party might want to let outsized developers including China Evergrande go if they could, in order to teach lessons to the over-leveraged private sector and write off unproductive assets from the economy. In the meantime, the already wealthy state sector and the Communist Party become richer, thus widening the gap between the ‘haves’ and the ‘have-nots’. President Xi Jinping might want something akin to hard-landing in order to facilitate structural changes. However, a wing in the CCP that has stronger vested interest in the status-quo might be standing in the way of such temptations for fear of squandering 60 million or possibly more construction jobs. China should not keep relying on infrastructure projects in the face of falling marginal returns from new investments in high ways and high speed railways. Though the CCP is aware of it, the party lacks the will to swallow such a policy change, as the CCP has been dependent on job creation through economic growth for its legitimacy. Structural reform is so hard to carry out not only in Western democracy but also in autocracy. Mao Zedong might have made a bold decision single-handedly, defying objections from other wings in the party. In fact, Mao boldly carried out Great Leap Forward, letting tens of millions of people starve to death as a consequence. Xi Jinping’s grasp of power in the party is nowhere near Mao’s, China watcher Tsugami thinks. Inability to make tough decisions leaves China on the same path that Japan has been on since the burst of the bubble in the early 1990s, the path that CCP studied strenuously in order to avoid. About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.