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The Way We Were

Ichiro Suzuki

Moody’s has recently cut China’s outlook to ‘negative’. The move is often considered as a harbinger to a downgrade unless the country’s long-term outlook turns around. Without a turnaround, a negative watch is a gateway to a long-term descent that could last a generation. 

We’ve seen this before in Japan. The country once was awash with money, earning obscene amount of currency accounts surpluses, often driving the United States to wrath. Back in those days, Moody’s rated Japanese government bonds Aaa, a more creditworthy rank than anyone. That was a long time ago, and Japan’s A1 rating today is the lowest among G7 countries but for Italy.

At the height of economic might and creditworthiness, Japan suffered a bust of a historic bubble. At the apex of its economic boom, rating agencies had warned Japanese banks of their excessive exposure to real estate lending. The Japan Bankers Association then hit back at S&P and Moody’s, sending them a letter to insist that real estate in Japan was a special asset class with a long track record of not falling in prices. That was near the end of the 1980s. Rating agencies prevailed, of course. Banks were shamed, slipping into a quagmire of ever growing bad debts but still refused to see the reality. They thought the market would bounce back if they waited patiently perhaps a few years, as it always did in the past. The market didn’t come back and the size of debt debts kept growing, seriously imparting their capital base. The Ministry of Finance tried to fix the problem with a series of ineffective and half-hearted measures.

A vicious cycle of bad debts goes on in the following steps. Leverage rises excessively on the way to sky high real estate prices. Tight monetary policy puts brakes on the market. Real estate prices peak and then begin to fall. Leveraged players’ balance sheets get damaged by falling prices. Weakened borrowers then hit lenders as non-performing loans (NPLs) build up. Damaged banks become unable to extend loans. Fewer loans weaken economic growth despite the government efforts to boost growth through fiscal policy. Lower growth prospects and greater government debt lead to lower credit ratings. Lower credit ratings raise borrowing costs. Higher interest rates again dampen growth. Lower growth creates even more new NPLs.

In order to get out of this negative feedback loop, the banking system needs to be recapitalized, ultimately with injection of taxpayers money by the government. In this process, value of bank assets has to be brought down to the levels that are in line with their market value, with a huge amount of bad debts to be written off. What they have been hiding needs to be exposed. Massive write-offs shame bank management and draw public fury. They are reluctant to do it but this needs to be done eventually. 

After many bank failures in the late 1990s and failed attempts to rescue the system, it was not until 2003 when the Japanese government embarked on aggressive overhauling of the banking system at last. In 2001 Jun-Ichiro Koizumi unexpectedly won a Liberal Democratic Party president election to become a new prime minister. Then he dared to face the problem, and decided to inject massive amount of taxpayers’ money into the banking system to solve the banking problem once and for all. Professor Heizo Takenaka drew the plan and executed it, and it worked. After a dozen years since the first sign of unraveling of the banking system, the government finally made up its mind on a bailout program with teeth. Though the LDP held onto power during what was originally projected as a lost decade, several prime ministers came and went. 

The ordeal that the Chinese economy is facing sounds too familiar to us in Japan. China has been following the footsteps Japan had gone through in the 1990s, despite their original determination not to repeat Japan’s missteps. There is, however, one thing that separates China today from Japan in the 1990s. It is the absence of Chinese real estate prices’ sharp fall whereas the Japanese market fell a stunning 75% from the peak. China’s real estate prices are relatively steady despite near bankruptcy of leading private sector developers. It is not entirely certain how the market is kept afloat, but it can be done with a limited numbers of transactions that are materially, probably artificially, above what the vast majority of potential buyers would like to pay. This could be done in China with the CCP flexing its muscles, with private sector companies having been driven out. In the absence of real estate prices’ collapse, NPLs do not balloon on banks balance sheets, and hence do not trigger a banking crisis. In a tightly controlled economy, China might be succeeding in indulging itself in artificially created calmness. 

This is tantamount to feeding an unproductive part of the economy at the expense of others that are more productive. The government makes every effort to keep the real estate market from collapsing through intervention into the market mechanism, and the zombie companies that are kept afloat pay interest to banks and bond holders. Some China watchers estimate that these unproductive financial costs, interest paid by zombies, run as high as 3% of GDP. The majority of such interests is received by state-owned banks. The unproductive state sector gets bloated further at a time when foreign capital is beginning to leave China. 

The endgame would not be pretty. For the real estate market to be revitalized with new money in it, prices would have to be much lower. If the CCP thinks a patient waiting game would get themselves out of the woods, like Japanese banks wished at the outset, it would require them a far longer time than they would afford to wait. And there is no guarantee that the CCP could bend the market to their will for a very long time. As long as real estate prices are kept at artificially high levels, economic activities remain subdued. In an economy where real estate accounts for almost 30% of it, persistent doldrum from this sector could weigh on the CCP’s ability to rule the country with growing discontent among people. Above anything else, people’s trust in President Xi Jinping is going to be seriously eroded. President Xi is always right, they are told. People, however might revolt against the absolute ruler if he keeps falling to deliver. 

Mr. Suzuki is a retired banking executive based in Tokyo, Japan.


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