The dismal decade (Part 5: China and Japanification risks)

The dismal decade (Part 5: China and Japanification risks)

Phuah Eng Chye (27 April 2024)

In June 2023, Nomura Research’s Richard C. Koo[1] warned that China’s real estate malaise were symptoms of the potential Japanification of its economy. Richard C. Koo cautioned “China was likely to enter a balance sheet recession and needed to take urgent action to head off a protracted, Japanese-style downturn…What is particularly worrying is that China appears to be stuck in a liquidity trap, whereby a dearth of willing and solvent borrowers renders cuts in interest rates ineffective. Only more forceful fiscal stimulus – mainly to boost consumption by restoring confidence in a property market where developers have yet to complete unfinished projects – can avert a downward spiral”. Richard C. Koo (his famous hypothesis is that private sector balance sheet retrenchment was the main cause of Japan’s prolonged stagnation) comments triggered a flurry of articles comparing China today and Japan in the 1990s.

The Japanification debate owes its significance to the high-stake economic race between US and China. If China’s economy sinks into the Japanification hole of eternal deflation as some suggest, then China is unlikely to ever catch up with the US. It is a complex assessment though as Japanification has many dimensions. Japanification can be considered a prolonged version of secular stagnation (demographic-driven downcycle, demand deficits) and a milder version of a liquidity trap (debt dynamics and risk aversion inhibits private credit growth despite low interest rates). I would also highlight there are three different phases of Japanification; namely the start (i.e. events leading to the formation of asset price bubbles), the middle (how Japanification became entrenched after asset prices collapsed and the end-state (an anorexic and financialised economy, liquidity trap, secular stagnation).

How Japan became Japanified

The term “Japanification” is loosely used to refer to Japan’s Lost Decades – a period of sub-par economic growth stretching more than 25 years. Robin Wigglesworth describes it “simply as a protracted period of deflation, economic sluggishness, property market declines and financial stress as households, companies, governments unsuccessfully try to deleverage after a debt binge”.

How did it get there? Joshua Felman and Daniel Leigh explains “Japan was one of the world’s fastest-growing economies for three decades but has averaged only 1.1 percent real GDP growth since 1990, while prices have steadily declined. Consequently, the size of Japan’s economy today is about the same as in the early 1990s”. They examined “whether the Plaza Accord[2] was really the direct cause of Japan’s Lost Decades”. In effect, the 1985 Plaza Accord agreement for Japan and Germany to boost domestic demand and appreciate their currencies “marked a major change in policy regime: the Federal Reserve was signaling that after a long and successful fight against inflation, it was now prepared to ease policies, allow the dollar to decline, and focus more on growth. This signal was backed by coordinated currency market intervention and a steady reduction in U.S. short-term rates. Accordingly, it triggered an exceptionally large appreciation of the yen, amounting to 46 percent against the dollar and 30 percent in real effective terms by the end of 1986. (The deutsche mark appreciated similarly)”. “As a result, Japan’s export and GDP growth essentially halted in the first half of 1986. With the economy in recession and the exchange rate appreciating rapidly, the authorities were under considerable pressure to respond. They did so by introducing a sizable macroeconomic stimulus. Policy interest rates were reduced by about 3 percentage points, a stance that was sustained until 1989. A large fiscal package was introduced in 1987, even though a vigorous recovery had already started in the second half of 1986. By 1987, Japan’s output was booming, but so were credit growth and asset prices, with stock and urban land prices tripling from 1985 to 1989. Then, in January 1990, the stock price bubble burst. Share prices lost a third of their value within a year, and two decades of dismal economic performance followed”.

Joshua Felman and Daniel Leigh note studies suggesting “monetary policy easing may have been excessive”. While “a key reason is that current inflation remained reasonably well behaved…IMF reports at the time suggest another factor was also at work. The authorities worried that higher interest rates would further strengthen the yen and feared that appreciation would eventually have serious effects on the economy. In the end, external demand did indeed diminish. But it did not collapse. Real exports continued to grow in the five years after Plaza, by an average of 2½ percent a year (half the rate of the previous five years), while the current account surplus diminished by a moderate 2 percentage points of GDP. Put another way, excessive stimulus was adopted in part because there was excessive concern about the impact of appreciation”. “In Japan’s case, two other elements seem to have played a large role…financial deregulation in the 1970s and early 1980s…leading banks to lend instead to real estate developers and households seeking mortgages. As a result, bank credit to these two sectors grew by about 150 percent during 1985–90, roughly twice as fast as the 77 percent increase in overall bank credit to the private sector. Finally, because the dangers of real estate bubbles were not well understood in those years, the Japanese government did not deploy countervailing regulatory and fiscal policies until 1990”.

Joshua Felman and Daniel Leigh points out “the aftermath of the bubble proved extraordinarily painful for Japan. But the collapse of a bubble does not inevitably have such powerful and long-lasting effects. What was special about Japan’s case? A key factor was the buildup of considerable leverage in the financial system, similar to what occurred in the United States before 2008. Tier 1 capital of Japanese banks in the 1980s was very low, much lower than elsewhere, as global standards (the Basel I accord) had not yet gone into effect. Moreover, much of the collateral for loans was in the form of real estate, whereas under the keiretsu system a significant portion of bank assets consisted of shares in other firms from the same group. So, when real estate and share prices collapsed, the banking system was badly damaged. This underlying vulnerability was exacerbated by a slow policy response. The authorities delayed forcing banks to recognize the losses on their balance sheets and allowed them to continue lending to firms that had themselves become insolvent…zombie lending. This process continued into the early 2000s, stifling productivity growth and prolonging Japan’s slump. Why did the authorities not force faster restructuring? Possibly because restructuring would have required additional bank capital, which they were not in a position to provide in light of the strong political backlash after an initial injection of public capital in 1995. Consequently, the authorities exercised forbearance instead. The post-bubble slump may also have been exacerbated by the macroeconomic policy response and adverse external shocks. Some argue that premature monetary tightening and the lack of a clear commitment to raising inflation led to unduly high real interest rates. In addition, the tightening of fiscal policy in 1997 may have undercut the nascent 1995–96 recovery. Finally, adverse external shocks played a role, including the 1997–98 Asian financial crisis. In sum, Japan’s experience shows that currency appreciation does not, in fact, inevitably lead to lost decades. The appreciation did not inevitably require such a large macroeconomic stimulus. The stimulus did not inevitably lead to the bubble. Nor did the bubble’s collapse inevitably lead to the Lost Decades. Instead, it was the particular combination of circumstances and choices that led to that result”.

Wang Liwei, Wang Shiyu and Denise Jia adds “in March 1990, the Ministry of Finance imposed restrictions on property lending and required banks to report the status of loans to real estate, construction and nonbank borrowers…Unlike the crash of the stock market, property prices fell more gradually in the 1990s. When the real estate slump and economic deceleration was aggravated by the enforcement in January 1992 of the land value tax” (the tax was later shelved). “The burst of the asset prices left overly leveraged Japanese banks and insurance companies with a load of bad loans. By 1995, it was clear to many economists and financial experts that the most serious problem facing Japan was bad loans…The government had at first estimated a size of 30 trillion yen (US$211 billion) of bad loans, and had expected it would take at most five years for large banks to absorb the losses, according to the former finance ministry official. When banks were forced to slash about 100 trillion yen, or US$885 billion at the time, of bad loans while taking drastic measures to reduce risk, they found the size was way more than their capability to absorb”. “The 1997 Asian financial crisis made matters worse…as Sanyo Securities, a mid-sized securities firm, and Hokkaido Takushoku Bank, the smallest of the country’s 20 largest banks, went bust…followed by the collapse of Yamaichi Securities, which had been one of the four major Japan’s brokerages…In 1998, two important financial regulatory reform laws – the Financial Reconstruction Act and the Rapid Recapitalisation Act – were passed in Japan, allowing the government to use 30 trillion yen of public funds to protect depositors of failed banks and provide assistance for troubled banks…the Program for Financial Revival, known as the Takenaka Plan, which required a more rigorous assessment of bank assets, an increase in bank capital and stronger supervision. As a result, Japanese banks cleaned up about 90 trillion yen worth of non-performing assets. That is equivalent to 90% of all Japanese banks’ loans from 1985 to 1989…But it took the government 15 years to tackle the bad loans. If the finance ministry had dealt more decisively with the bad loan problem in the mid-1990s, Japan would not have experienced a financial crisis of this magnitude”.

Why is China being compared with Japan?

Han Feizi notes “China’s economic growth has followed what’s sometimes called the Japanese model. In Japan and other Asian countries, this model has proved extraordinarily successful in the short term in generating eye-popping rates of growth – but it always eventually runs into the same fatal constraints: massive overinvestment and misallocated capital. And then a period of painful economic adjustment. In short: Beijing, beware. According to the narrative, China is now facing a Japan-style reckoning with its property sector stuck in the doldrums for over three years…Japan is sui generis. No nation’s economy has underperformed so lamentably for so long after outperforming so spectacularly for even longer”.

Certainly, the similarities between China’s rise to challenge US dominance with Japan in the 1990s are unmistakeable. Japan’s share of the global economy peaked at 18% in 1994. China reached 18% in 2023. Their economic rise was characterised by export-led manufacturing growth, huge trade surpluses and FX reserves, overinvestment, high household savings, suppressed domestic consumption and credit-fuelled asset price bubbles.

JPMorgan analysts[3] Haibin Zhu, Grace Ng, Tingting Ge and Ji Yan point out “China’s total non-financial credit/GDP ratio approached 297% of GDP by end-2022, similar to Japan in the 1990s”. Due to high domestic savings, most debt is local currency with both countries ranking among the largest creditor nations. Samsara Wang and Ilke Pienaar thinks “China is heading down a similar path to Japan in the 1990s – including deteriorating demographics, persistent low inflation, declining growth, and high debt levels, along with low consumer confidence and decreased private investment”.

Nicholas Spiro thinks China’s “record youth unemployment, lacklustre consumer spending, the threat of outright deflation, a festering crisis in the property market and severe strains on heavily indebted local governments carries troubling echoes of Japan in the 1990s”. He notes just as Japan struggled with excess credit growth, exposure to non-performing loans and unproductive zombie companies, China faces a similar challenge in dealing with heavily-indebted state-owned enterprises that survive only by relying on government support.

Some economists think China faces a bigger challenge than Japan. Ye Xie points out “China’s economy is more reliant on the construction industry. At 26% of GDP, the size of the sectors is comparable in both countries. But the strength of other Japanese industries, such as auto and tech, softened the blow. Unfortunately, China doesn’t have similar industries that could fill in the void left by the housing slump”.

Differences between China today and Japan in 1990

Asset price bubbles accompanied the rise of Japan and China. When these bubbles were punctured, both economies experienced a painful economic adjustment. However, there noticeable differences between China’s and Japan’s asset price bubbles. Land prices in Japan reached 560% of its GDP in 1990 while stock market capitalisation was 142% of GDP in 1989. China’s real estate value is currently at 260% of GDP and stock market capitalisation at 67% of GDP – much lower than Japan. Samsara Wang and Ilke Pienaar think “China’s asset bubbles are not as large as Japan’s. Before the burst in Japan, the Nikkei 225 was trading at 60x price/earnings, while the Shanghai Composite Index is only around 14x currently. Japan’s asset bubble bursts were also exacerbated by the strong yen exchange rate versus the US dollar. The yen appreciated around 45% against dollar from 1985 to 1990. Meanwhile in China, the yuan has depreciated 4.7% against the dollar during the past five years, partly driven by the trade-weighted US dollar, which appreciated by 8.6%”.

Han Feizi adds “today, like in 2010, commentary on China’s Japanification is far off the mark. China bears only superficial similarities with Japan, namely a property bubble, which in China’s case is so far a controlled demolition rather than chaotic collapse”. Tommy Xie  points out “the increase in the number of Chinese households paying off their mortgages early is mainly a result of the mortgage interest rate being higher than the deposit interest rate…On top of that, credit and investment in China’s corporate sector are on an uptrend, in stark contrast with the stagnation experienced by the Japanese economy…looking at the medium- to long-term trends, China differs from Japan 30 years ago in three ways. First, on the one hand, the sharp rise in the yen was a key reason behind Japan’s asset bubble; on the other hand, the Chinese RMB is still facing depreciation pressures, and the government has control over the exchange rate. Second, China’s GDP per capita and the proportion of its middle class are lower than that of Japan then, so the bursting of the asset bubble would not have widespread impact. Third, Xie noted that China’s big government and large market have major influence over the allocation of resources. Furthermore, the Chinese economy is not as closely linked with the US, as was the case for Japan at the time. Hence, China has greater autonomy over its policies, and can do much more than Japan could”.

Joshua Felman and Daniel Leigh suggest “circumstances in China today differ from those in Japan in the 1980s in ways that should help it avoid Japan’s disappointing outcomes. First, the leverage of households, corporations, and the government in China is lower now than it was in Japan before the bubble, and the risk of excessive borrowing may thus be smaller. Second…climbing the quality ladder helps offset the impact on growth of currency appreciation, and China has more room to climb the export quality ladder than Japan did. Third, Japan had a floating exchange rate regime in the 1980s, but China has a managed exchange rate supported by vast foreign currency reserves and strong restrictions on capital inflows. This difference in currency regimes should help China avoid the sharp appreciation observed in Japan. Most important, China should be able to reap the benefits of learning from Japan’s experience”.

JPMorgan analysts[4] point out “balance sheet recession is not a reality yet in China. The Chinese government has adopted the strategy of protecting house prices but letting volumes correct dramatically. This is in sharp contrast to the Japan’s episode, when prices and volume fell simultaneously. As a consequence, the macro cost (sharp decline in volume activity and slower real estate investment) is larger in China, but the benefit is that financial risk associated with asset price decline has stayed under control. Also Japan’s balance sheet recession manifested itself in a huge deleveraging by households and companies…Corporate debt fell from the peak of 144.9 per cent of Japan’s GDP in 1993 to 99.4 per cent in 2004, and household fell from 71 per cent in 1999 to 60 per cent in 2007, even as government debt ballooned, pushing the overall burden for the economy as a whole higher. In contrast, China’s debts have been building up across the board with hardly any interruptions since 2008, and this is likely to continue, according to JPMorgan…But the fact that Chinese debts have continued to rise and are likely to do so for the next few years – and that the property market hasn’t imploded yet – is not really an argument against China’s Japanification. Indeed, it might only indicate that a full-scale version just hasn’t started yet”.

JPMorgan analysts[5] think “China’s housing price overvaluation is less severe than Japan in the 1990s. This is in part due to prolonged administrative control on new home prices and in part due to solid income growth. Our estimates show that housing affordability has continued to be a big problem in tier-1 cities: it took 21.1 years of household income to buy a 90-sqm apartment in 2010, and 16.6 years of household income in 2022. By contrast, housing affordability is much better in tier-2 and tier-3 cities that account for the majority of China’s housing market. Using the same house price/income measure, the ratio fell from 13.4 in 2010 to 8.3 in 2022 in tier-2 cities, and from 10.2 in 2010 to 6.1 in 2022 in tier-3 cities”.

Ye Xie notes Richard Koo finds it puzzling “that China’s deleveraging seemed to have started well before the housing bust in 2020. Corporations have stopped borrowing at times since 2015, suggesting something else has sapped the animal spirits of the private sector. (The timing coincided with the government’s supply-side reform that targeted eradicating overproduction capacities in various industries)”.

Goldman Sachs’ Hui Shan suggest “healthy Chinese companies, unlike firms in Japan in the 1990s, aren’t reluctant to invest because their balance sheets are impaired, but rather because of regulatory tightening and policy unpredictability…most of the decline in Japan’s potential growth rate in the 1990s can be explained by the falling contribution of investment on worsening growth expectations…By contrast, labor’s contribution played a relatively small role. Deteriorating long-term growth expectations rather than deteriorating demographics were at the core of Japanification”.

Samsara Wang and Ilke Pienaar points out “critically, no major financial institutions have failed. China banks’ non-performing loan ratio is also low, at 1.6% as of June 2023, down markedly from 12.4% in March 2005. For Japan, there was no Basel Capital Accord at the time. Japanese banks’ loans were overextended, especially in risky areas without adequate regulations. The economy’s slowdown and deflation soon led to surging non-performing loans. The failure of Toho Sogo Bank in 1991 was only the first, and failures of small financial institutions accelerated in 1994 and 1995. During the 1997 Asia financial crisis, major security houses collapsed”.

Samsara Wang and Ilke Pienaar also argue the root cause of slowing growth differs. The current slowdown in China’s economy was mainly caused by 1) strict lockdowns during the pandemic; 2) unexpected government policy clampdowns on several key sectors, including technology, education, and (most importantly) property; and 3) US-China tensions. This suggests the slowdown is part of China’s painful process to diversify away from the traditional growth drivers of property and infrastructure investment to the new drivers of high-end manufacturing and self-reliance on high-tech sectors. Unfortunately, the pandemic hit at the same time. As for Japan, the Lost Decade was caused solely by asset bubble bursts in both the property market and the stock market. These bubbles were fueled by expansionary fiscal and monetary policies after the 1985 Plaza Accord. In order to fight high inflation and asset price speculation, the Bank of Japan was still hiking rates in May of 1989 and ultimately cut too late (in June of 1991)”.

Learning from Japan

William Pesek  ponders “today, as China grapples with a midlife economic crisis, it would be better if Japan found a way out of its own problems. If only Tokyo was able to impart a full case study for Beijing, London, New Delhi, Seoul and elsewhere struggling to avoid lost-decade ignominy. China would benefit from such insights”. The risk is that as China’s population age, the higher the risks of its “economy being trapped in deflation”. “Watching Xi’s team slow-walk ending a property-sector crisis, one can’t help but notice parallels to Japan’s bad-loan nightmare of the 1990s and 2000s”. “Tokyo’s lessons for Beijing are clear: move boldly and transparently to fix the property sector, create broader social safety nets to encourage consumption over saving, and tackle inefficiencies to weed out zombie companies and sectors. Not that Japanese officials are acting accordingly, but Xi’s inner circle is convincing virtually no one it is on top of China’s fast-mounting troubles or that a Japan-like slump can be avoided”.

Nicholas Spiro explains “because Chinese policymakers are sensitive to the mistakes made by Japan, it is unlikely they would allow a full-blown balance sheet recession to take hold. Beijing has had plenty of time to learn from Tokyo’s costly policy blunders”. However, “comparisons between China and Japan are inapt in several crucial areas. Not only did Japan allow the yen to strengthen sharply in the years preceding and following the bursting of its bubble, it kept real interest rates above the rate of economic growth and maintained an overly restrictive fiscal stance in the 1990s. By contrast, China carefully manages its currency, ensuring the yuan trades in a tight range versus other major currencies. More importantly, China benefits from its state-owned financial system that makes a systemic crisis in the banking sector highly unlikely. Furthermore, strict controls on the country’s capital account significantly reduce the risk of major capital flight…The declines in asset prices in China, particularly in the property market, have been nowhere near as catastrophic as the falls in Japan in 1990 and the US in 2008. Beijing’s penchant for control – as opposed to Japan’s more market-driven system – not only provides a financial backstop, it helps buy China time to shift to a consumption-driven growth model, a conceivable prospect given that it still has plenty of economic catching-up to do”.

Consistent with his balance sheet recession theory, Richard Koo[6] advised “don’t waste time on monetary policies, or structural reforms. Instead, focus all energy on fiscal stimulus to keep the economy going…complete all the unfinished housing projects at any cost to avoid a collapse…I hope Chinese policymakers understand and respond to these challenges, because this might be the last chance for China to reach the living standards of the First World.” Richard C. Koo’s thesis is that governments need to maintain a sufficient level of fiscal expenditures to effectively offset private sector balance sheet retrenchment.

Wang Liwei, Wang Shiyu and Denise Jia think “Japan’s experience may offer lessons to Chinese policymakers about how to battle prolonged stagnation”. “Amid strong wage growth and rising prices, Japan is finally emerging from the quagmire of almost three decades of deflation…Japan, the world’s third largest economy, has suffered from sluggish economic growth and recession since the early 1990s, yet it has maintained its status as a highly developed economy, avoiding the middle-income trap. The country has maintained fiscal sustainability, social stability and welfare levels, all while dealing with an ageing population. Where potential lessons may lay are in the answer to the question of whether Japan could have avoided years of zero growth had it pursued different monetary policies or adjusted its policies sooner”. They note comments that “China can steer clear of such a debt-deflation spiral if policymakers act quickly and decisively. To do so, China must resist the head-in-the-sand ostrich mentality that prevented Japan from identifying its crisis sooner, and avoid the hesitation and repeated wavering in easing monetary policy”. They add “Japanese government’s efforts to address weak demand offers valuable lessons to China as households in both countries have a high savings rate and are unwilling to spend…After the bubble burst, Japanese government spending increased rapidly to stimulate growth, but much of it was invested in inefficient infrastructure…Like China today, Japan’s private sector then had abundant savings and insufficient investment. Increased government debt would promote output growth and employment, without leading to inflation, excessive demand or threatening the government’s credit”.

When analysing Japan’s policy response, two phases need to be differentiated. In their initial response, the Japanese government was criticised for policy missteps – from over-reacting to the yen appreciation, for underestimating the severity of the crisis by keeping policy tight and followed by stop-go policies – injecting stimulus to boost consumption and then tightening too quickly which killed the fledging recovery. Lax oversight of the financial system and regulatory complacency in cleaning up bad loans meant that governments failed to revive the economy, markets and private sector activities despite repeated attempts.

In the latter phase, in 2013 Prime Minister Shinzo Abe launched his Abenomics policies with three arrows: (i) aggressive monetary policy, (ii) fiscal consolidation, and (iii) growth strategy. William Pesek notes Shinzo Abe promised a supply-side revolution including “cutting red tape, modernising labour markets, encouraging innovation, empowering women and convincing multinational companies that Tokyo is a solid place to invest”. In 2013, Haruhiko Kuroda was appointed as BOJ governor. “Within five years, Kuroda’s binging on bonds and stocks pushed the BOJ’s balance sheet above $4.9 trillion, topping Japan’s annual GDP. A resulting plunge in the yen boosted exports, juicing the stock market and generating record corporate profits”. The hope “was that turbocharged quantitative easing would kick off a virtuous cycle. The weak yen would finally spur companies flush with profits to fatten pay cheques and spark a consumption boom”. Despite the stockmarket boom, Sayuri Shirai notes “this time a falling yen isn’t altering Japan’s export and trade deficit dynamics like in the past. Industrial production and corporate investment also remain sluggish…Wage growth has not caught up with the rate of inflation”. William Pesek thinks the fault lies with “Tokyo’s continued obsession with keeping the yen weak to support exports and corporate profits…There is a huge problem with this strategy: it’s the same one Tokyo has pursued since the mid- to-late 1990s. It is also at the heart of why Japan has never quite shaken off two-plus decades of negligible growth, stagnant wages and fallout from China surpassing it…One can point to myriad reasons Japan Inc. refuses to raise its game. They include a change-averse political system, epic bureaucracy standing in the way, a sense of national pride that Tokyo does economics better than anyone and changing governments too often for big reforms to get implemented”. “Delay tactic after delay tactic cost Japan decades it can never get back”.

Abenomics pioneered a macroeconomic-focused policy template of expansionary fiscal policy and aggressive QE that led to negative interest rates; a policy combination many countries eagerly adopted during the pandemic. But Abenomics may have placed the Japanese economy and government in a precarious position. The financial system has become extremely fragile after decades of low interest rates. Central bank monetisation of huge fiscal deficits created a captive, illiquid JGB market. BOJ is finding difficulty to exit its QE program. A sudden rise in interest rates would increase the government debt servicing burden and wreck significant collateral damage on its financial institutions and retirees. Yet, if it persists with its low interest rate policy, it will increase the pressure on the yen.

My view is that China should learn from Japan by not adopting their “failed” policies. Not only did Japanese policies fail to avert Japanification, their initiatives via large-scale fiscal stimulus and QE, zero-bound interest rates, financial repression and the slow pace of market clearing probably left the economy in a more precarious state. BOJ has dug a bigger QE hole and is in a predicament as to how it can exit its QE trap. As a matter of comparison, Japan’s depression lasted three times longer than the 1930s Great Depression albeit it was a milder variety with low unemployment. Today, some argue that the Japanese economy, or at least its stockmarket, is on the verge of a recovery. I am yet to be convinced that Japan is in a good place.

The debate on structural challenges

Many argue Japanese policies failed to lift the country out of its lost decades because it was too feeble in addressing its structural challenges. In this context, conventional structural reforms have tended to focus on weaning economies off over-investing in manufacturing (reducing global over-supply) and on strengthening household consumption via labour and welfare reforms. But these “institutionally-supported” structural reforms tends to “domesticate” rather than “energise” an economy. Japan certainly faced many structural challenges and the issue of what would have been appropriate structural reforms is heavily debated.

  • The debate on aging

Aging features prominently in Japanification. Novelist Nire Shūhei newest work Genkai Kokka (Marginal Nation)[7] “opens with a senior Japanese business figure…request research into the future of Japan. At the root of his sense of crisis are the dwindling birthrate and aging population. Demographics suggest that the population of Japan will fall to around 86 million by 2060, a drop that would involve a host of serious problems: the depopulation and collapse of rural communities, the bankruptcy of the current economic model based on domestic demand, professional lives cut short by AI, issues with immigration, the collapse of traditional culture, and an exodus of Japanese talent in search of better opportunities overseas”. He explains “population decline is a terrifying thing, especially for an economy like Japan’s that is so dependent on domestic demand – which accounts for about 70 percent of the total economy. In the decades to come, the size of the economy will naturally shrink, and the current economic model, based on domestic demand, will become untenable by the 2040s. How will the country forge a new way forward when this happens? This is a critical question, but so far there has been virtually no serious discussion about it”. “To maintain a population of 100 million, Japan needs a total fertility rate of 2.07…slightly more than two children on average. But in Japan today, this has fallen to just 1.2”. While the Japanese government have launched various initiatives to encourage child-bearing, changing lifestyle preferences and rising costs associated with raising a child (e.g. housing, education) are working against it.

Aging is a major long-term challenge in China. C.H Kwan notes “while low birthrates and population aging are phenomena common to developed countries, with Japan being a leading example, China has to face this severe challenge before it becomes affluent…China’s birthrate is falling faster than Japan’s. In addition to the implementation of birth restrictions symbolized by the one-child policy that began in 1980, other contributing factors include the trend toward non-marriage and late marriage, and declining female fertility. From 1980 to 2020, the total fertility rate in Japan fell from 1.75 to 1.29. In the same period, China’s total fertility rate fell from 2.74 to 1.28…The total population of Japan decreased from a peak of 128 million in 2009 to 125 million in 2020, and the UN predicts it will fall to 104 million by 2050. Meanwhile, China’s total population increased from 982 million in 1980 to 1,425 million in 2020, and is predicted to decline from a peak of 1,426 million in 2021, to be overtaken by India in 2023, and to shrink to 1,313 million by 2050”.

C.H Kwan notes “in both China and Japan, declining fertility rates have not only curbed population growth, but have also significantly changed the age structure of the population. Looking at the three categories of the population: children aged 14 and under, the working-age population aged 15-59, and the elderly aged 60 and over, the proportion of the child population in Japan declined from 23.1% to 11.9% between 1980 and 2020, while the proportion of the elderly population surged from 13.1% to 35.4%. Reflecting the fact that the aging of the population is outpacing the decreasing child population resulting from low birthrates, the proportion of the nonworking-age population, has been rising. Conversely, the proportion of the working-age population, which peaked at 65.9% in 1968, declined further from 63.8% to 52.6% between 1980 and 2020. In China, on the other hand, from 1980 to 2020, the proportion of the child population halved from 36.1% to 18.0%, while that of the elderly population rose from 6.9% to 17.8%. The proportion of the working-age population rose from 57.0% in 1980 to 69.2% in 2007 before dropping to 64.1% in 2020. This means that the demographic bonus that supported economic growth has turned into a demographic burden. In 2020, the proportion of the child population and that of the elderly population in China were equivalent to their respective levels in Japan in 1990, and the proportion of the working-age population was equivalent to the 1989 level in Japan. Thus, the age structure of the population in China in 2020 was similar to that of Japan around 1990. The low birthrate and aging population are expected to continue in both Japan and China in the future. According to United Nations (UN) projections, in 2050, the proportion of the child population in Japan will fall further to 11.1% and that of the working-age population to 45.2%, while the proportion of the elderly population will rise further to 43.7%. As for China, the proportion of the child population will fall further to 11.4% and that of the working-age population to 49.7%, while the proportion of the elderly population will rise to 38.8%. One factor behind the aging of the population is the increase in life expectancy. From 1980 to 2020, life expectancy in Japan and China increased from 76.1 to 84.7 years and from 64.4 to 78.1 years, respectively. The UN predicts that China’s life expectancy will rise to 83.8 years in 2050, approaching the level of Japan (88.3 years). Japan experienced a period of rapid growth after the end of World War II, but growth has been declining since the first oil shock in 1973, and the same trend has been observed in China since the beginning of the 2010s. A falling birthrate and aging population are holding back growth through a shrinking labor force and lower savings rates (and thus investment rates). To sustain economic growth, in addition to the birthrate and the labor participation rate, productivity must also be raised”. “Against the backdrop of an aging population, the savings rate (the ratio of savings to GDP) in Japan and China peaked at 34.1% in 1991 and 50.7% in 2010, respectively, before declining to 24.6% and 45.7% in 2021. Reflecting the fact that the majority of investment is funded by domestic savings, the investment rate (the ratio of capital formation to GDP) in both countries has declined in tandem with the savings rate. The slowdown in investment means stagnating capital accumulation, which, along with a shrinking labor force, reduces the potential growth rates of both countries. As a countermeasure, it is necessary to increase productivity through the acceleration of innovation and industrial upgrading”.

Jose Caballero reports in 2023, China’s “population declined from 1.4118 to 1.4097 billion people. Forecasting by the UN suggests China’s population will dip to 1.313 billion by 2050 and then down to about 800 million by 2100…There are two trends that underline such a demographic shift. First is the aging population with the percentage of those aged 60 and older currently above 20% of the total population. Second, birth rates have dropped significantly, from 17.86 million births in 2016 to 9.02 million in 2023…More than one-quarter of China’s population will be over 60 by 2040 and so less economically active (retirement age for men is 60 and for women it’s 50-55). This will put pressure on China’s pension and elderly care systems with some predictions indicating that the pension system could be bankrupted by 2035”.

Jose Caballero notes “some studies find evidence that labor productivity (output per working hour) varies with age. It tends to increase as a person enters the labor market, then plateaus between 30 and 40, and eventually declines as an individual’s work-life comes to an end. Population shifts can lead to a doom loop where one economic situation creates a negative impact and then another and another. As lower productivity begins to affect production in particular sectors, China may be compelled to increase imports to satisfy demand in those industries. This could significantly affect innovation and entrepreneurship, which in turn can further diminish productivity. New ideas drive economic growth. The size of the workforce affects innovation because as the number of employed individuals shrinks, the pool of new ideas becomes narrower”.

Xiujian Peng notes “the National Bureau of Statistics reports just 9.02 million births in 2023 – only half as many as in 2017. Set alongside China’s 11.1 million deaths in 2023, up 500,000 on 2022, it means China’s population shrank 2.08 million in 2023 after falling 850,000 in 2022. That’s a loss of about 3 million in two years…China’s total fertility rate, the average number of births per woman, was fairly flat at about 1.66 between 1991 and 2017 under China’s one-child policy. But it then fell to 1.28 in 2020, to 1.08 in 2022 and is now around 1, which is way below the level of 2.1 generally thought necessary to sustain a population. By way of comparison, Australia and the United States have fertility rates of 1.6. In 2023 South Korea has the world’s lowest rate, 0.72”. “Shanghai Academy of Social Science projects China’s working-age population will decline to 210 million in 2100 – a mere one-fifth of its 2014 peak”. “The same research team at the Shanghai Academy of Social Sciences and the Centre for Policy Studies at Australia’s Victoria University have China’s population falling by more than one-half to around 525 million by 2100, a fall about 62 million bigger than previously forecast. The working-age population is set to fall more sharply to 210 million. We now expect the number of Chinese aged 65 and older to overtake the number of Chinese of traditional working age in 2077, three years earlier than previously. By 2100 we expect every 100 Chinese of traditional working-age to have to support 137 elderly Chinese, up from just 21 at present. Our central scenario assumes China’s fertility rate will recover, climbing slowly to 1.3. Our low scenario assumes it will decline further to 0.88 over the next decade and then gradually recover to 1.0 by 2050 before holding steady. We have based our assumptions on observations of actual total fertility rates in China’s region and their downward trend. In 2022 these rates hit 1.26 in Japan, 1.04 in Singapore, 0.87 in Taiwan, 0.8 in Hong Kong and 0.78 in South Korea. In none of these countries has fertility rebounded, despite government efforts. These trends point to what demographers call the low-fertility trap in which fertility becomes hard to lift once it falls below 1.5 or 1.4”.

Han Feizi has a more optimistic perspective. He notes “China’s births have been cut in half since 2016. Though below the replacement rate of 2.1, China’s birth rate had been running at a tolerable 1.6 to 1.8 for decades. We’ll be okay; it’s higher than Japan’s 1.3, Chinese demographers surely told themselves. Any such confidence should have evaporated in the past five years as the birthrate plummeted to a shockingly low 1.1 (still above South Korea)”. He wonders how much of China’s deteriorating demographic story is a result of China’s rapidly rising college enrolment. “At the turn of the century, China produced one million college graduates. This represented 6% of the age cohort…This has increased dramatically to 11.6 million graduates for the class of 2023, 63% of the age cohort. Over this time period, college graduates in the workforce increased from low single-digit percentages to 25%. With the working-age population peaking in 2011…China’s blue-collar workforce will transition to a white-collar one as retiring migrant workers are replaced by their college-educated children. College graduates in China’s workforce should exceed 70% by 2050. Of note, over 40% of China’s college graduates are STEM majors. This compares to 18% in the US, 35% in Germany, and 26% in the OECD…these STEM majors have taken China from a standing start to topping science and technology metrics like the Nature Index, the top 1% of cited papers, the top 10% of cited papers and WIPO PCT patents in recent years. In real-world terms, China’s technically proficient workforce has given it the industrial output of the US and EU combined…made significant technological leaps with their legions of fresh-faced engineers. This trend should have another 20 years to run, at which point China’s workforce will have more STEM grads than the rest of the world combined. All of this is more or less written in stone until 2043. The college grads and STEM majors China’s needs by then have already been born”.

Han Feizi believes “two anomalies strongly suggest a bounce in birth rates in the coming years. Covid’s effect on births from 2020 to 2023 should be fairly obvious. We expect a spike in births starting in late 2023 from couples who put off conceiving during the Covid crisis. The less obvious factor is the surge in college graduates starting in 2022…we believe recent university expansions have enrolled an additional 3 million students per year since 2017, taking them out of both the job and family formation market until graduation. This just so happens to coincide with both the sudden decline in births and the increase in youth unemployment. We believe family formation for the college-educated is delayed past 23.7 years of age, the average age at graduation. Educated young people often put off having children for graduate school, to establish professional careers, to play the field, to travel, to be young and hip in the city, etc. And some prolong their adolescence for so long that they entirely skip the biological imperative…If we had to guess…China’s birthrate should partially recover to around 1.5 in five years. Any further increase will need to come from effective natalist policies which we will leave to fate and the powers that be”.

Han Feizi adds “still, China’s population under 20, at 23.3%, is considerably higher than its Asian counterparts (16-18%) and in line with the US (25.3%) and Europe (21.9%). The country’s 65 and older population, at 14.6%, is also lower than that of the developed world (20.5%). While China will not lack young workers for another two decades, it remains to be seen whether births bounce post-Covid and as university enrollment plateaus. Compared to the Asian Tigers, China is the least likely to suffer Japan-style economic stagnation as a result of demographics, which, in any case, none of them has (yet)”.

Samsara Wang and Ilke Pienaar adds “China still has an abundant labor supply despite the peak in population growth – and the country will also enjoy healthy improvements in labor productivity over the medium term. China’s government still has leeway to extend the retirement age limit, and the transfer of surplus labor from the rural sector to urban areas still has a lot of room to run. By our estimation, if the government increases the retirement age limit by five years, an additional 60 million to 67 million people will join the labor force, which is around 7% of the total working population. Currently, 24% of China’s total employment is in the agriculture sector, while this figure is below 5% in both Japan and the US. China’s labor productivity year-on-year growth is expected to stay high versus the US (currently) or Japan back in the 1990s, driven by continued improvements in education and training.

Overall, it is difficult to please economists. Demographic aging is a trend in Europe and Asia. A population slowdown or contraction provides a welcome respite to global over-population risks. Sure, there is an adverse impact on economic growth. I think the tasks for economists is to design better economic policies in relation to urbanisation, dependency, depopulation, migration[8] and human capital to deal with the consequences from aging.

  • The debate on the middle-income trap

JPMorgan analysts[9] are concerned that “China is actually ageing more rapidly than Japan was, which has led to predictions that it will grow old before it grows rich – a kind of demographics-caused middle-income trap. In Japan’s case, the share of population aged 65 and above exceeded 10% in 1983, and exceeded 14% in 1994. The birth rate fell from 12.7 (per 1000 people) to 10.0 during that period. In China’s case, it took only 7 years (from 2014 to 2021) for the 65 plus population to increase from 10% to 14% of total population, and the birth rate has fallen faster from 13.8 (per 1000 people) to 7.5 during that period (and further down to 6.77 in 2022, similar to Japan in 2020 at 6.80). In addition, China’s total population started to decline in 2022, while Japan’s total population started to decline in 2008, nearly two decades after the start of the lost decade. Second, China’s GDP per capita was around US$12,800 in 2022, much lower than Japan in 1991 at US$29,470. While lower GDP per capita may imply higher growth potential, it suggests that China is becoming old and high-indebted before it becomes rich.

Yao Yang argues “China’s per capita income level is still low, standing at only one-sixth of that in the US. Even in Japan in the 1990s, it was nearly 80 percent of the US. China’s gap means potential, and China still has vast room to catch up”. The challenge is for China to unlock its high savings rate of around 45 percent into “either investment or technological progress, which will support economic growth” so as to sustain the creation of enormous wealth year after year. “If one must compare China’s economy with Japan’s, China’s current economic situation is more like that of Japan in 1970s when Japan’s economy was prosperous and achieving technological progresses on many fronts”. In this regard, “China’s economy has no structural problems. In fact, this is the best period in China’s history in terms of technological innovation and progress…leading the world in the field of future technologies, such as photonic chips, quantum computing, quantum communications, and nuclear fusion. These are probably the technologies and revolutions of the future…China enjoys strong industrial capability. In the next ten to twenty years, no country can possibly replace China’s position in the global industrial chain. On an industrial basis, China accounts for more than 30 percent of the world’s manufacturing industry”.

Weijian Shan notes “the accepted opinion is that China’s demographics, namely an aging and declining population, will ultimately thwart its long-term growth. But the data doesn’t support it…The size of China’s labor force plateaued in 2012 and began to gradually decline. Yet its GDP has doubled in the 10 years since then. Yes, China’s productivity increase has slowed in recent years, but it has still managed to propel economic growth”. He thinks that R&D and productivity increase will allow China to avoid the middle income trap and points out that the urbanization rate is only 65%, compared with 91% for Japan and 85% for the US.

Han Feizi notes “the contrarian consensus often points out that China’s debt-to-GDP ratio is at developed economy levels, far above its emerging market peers. This is confused thinking. Developing economies should have high debt – to build infrastructure, housing and industrial assets as quickly as possible – while developed economies should have low debt as years of cash flows pay off interest and principals. Young people should have mortgages while retirees should have nest eggs. In practice, this is NOT what has happened as rich countries borrowed to fund welfare programs and poor countries could not access credit. As such, China is actually the only economy doing debt correctly”.

Han Feizi adds that “while the Asian Tigers’ birthrates started declining about ten years after Japan, they fell more precipitously and at lower per capita GDP levels. Taiwan’s birthrate has just about fallen to Japan’s level while South Korea’s has sunk far below. Singapore and Hong Kong population charts look no better despite immigration being a viable option. What did not happen in any of the Asian Tigers is the hoary “getting old before getting rich” canard. Collapsing birthrates did not, in fact, prevent any of the Asian Tigers from catching up to and exceeding Japan’s per capita GDP. While the night is still young and the consequences of disastrous-looking population charts may still catch up with the Asian Tigers, falling birthrates since the 1980s may have perversely allowed two generations of Asians to devote themselves to career and commerce, fueling decades of growth”. “None of the four Asian Tigers (South Korea, Taiwan, Hong Kong and Singapore) have experienced multiple decades of stagnation. And all of their per capita GDPs, coming from far behind, now exceed Japan’s on a purchasing power parity (PPP) basis. South Korea shook off the 1997-98 Asian financial crisis, reformed its chaebols and moved up the value ladder. Taiwan integrated its economy with the mainland and became the world’s leading producer of semiconductors. While Hong Kong’s recent decade has been lousy, it was the result of underinvestment in housing and, at the end of the day, the trade and financial hub still outperformed Japan. And Singapore is just a rocket ship with a per capita purchasing power parity GDP now 2.6 times that of Japan’s”.

The key argument revolves around whether China’s currently low per capita income is a barrier or an advantage. In my view, China have already overcome many middle-income trap barriers. It is already the unchallenged world No.2 economy. China already boasts many features like indigenous technology, global firms and brands, top-notch infrastructure and cities and global domination of several industries. It doesn’t need breakthroughs to become a high-income economy; just stability. Mathematically, China is only a middle-income economy because of its huge population. Demographic aging will advance its per capita income. A point worth noting is that as a middle-income country, the question of excess investment does not arise because it can still generate positive externalities. In this context, the mal-investment arguments apply to Japan because it was already a developed country and the massive infrastructure spending defied depopulation trends.

  • The debate on deflation

The collapse of its property and equity markets and deflationary trends are used to support the argument that China is at risk of Japanification. Yu Hairong, Wang Liwei and Han Wei notes in 2023, China’s CPI “rose 0.2%, the slowest since 2010, and remained mired in negative territory throughout the fourth quarter, indicating falling prices…the producer price index (PPI)…has remained negative for 15 consecutive months, with an annual decline of 3%”. “The country’s GDP deflator, the widest measure of prices across the economy, contracted by 0.8%”. “This has served to deepen fears of deflation and sparked calls for more supportive policy measures”.

Wei Shangjin[10] argues “the greatest threat facing the Chinese economy today is a fall into a debt-deflation trap.” “China has encountered deflation several times over the past four decades, but each time quickly overcame it. The most significant deflation risks occurred in 1998 after the Asian Financial Crisis and in 2015 when the economy faced serious overcapacity resulting from post-2008 financial crisis stimulus. Globally, the most painful memories of deflation include the Great Depression in the US between 1929 and 1933 and Japan’s three decades of stagnant economy beginning in the early 1990s. Wei suggested that Chinese policymakers should urgently inject more liquidity into the economy to avoid a deflation-debt spiral. But for the lending channel to work effectively, China must reform its state-owned banks to ensure that financial institutions lend to the most productive firms, rather than creating artificial money flows. Unfortunately, China is unlikely to undertake these critical reforms anytime soon, said Wei, adding that an alternative policy package for the short-term is to pair an aggressive fiscal policy with monetary policy”.

Yu Hairong, Wang Liwei and Han Wei notes warnings “that the risk of persistently low prices may continue if macroeconomic policies are insufficient or delayed…Mounting deflationary pressures have pushed up actual borrowing costs in China” despite several rounds of rate cuts. “China is caught in a dilemma of high real interest rates and low nominal interest rates” which discourages investments. In this regard, there are mounting concerns that a deflationary spiral would lead to demand and investment deficiencies, lower production, higher unemployment, falling wages and higher real borrowing costs. According to Tatsuhito Tokuchi[11], “the experience of Japan over the past 30 years shows that if a country enters a period of sustained deflation, it is very difficult to reverse and return to relatively stable and moderate inflation”.

However, Chinese officials argue the deflation readings are an aberration and should not be misinterpreted. In November 2023, PBOC asserts deflationary “pressures are temporary. Prices are expected to remain low in the short term but will return to normal levels in the future…The stable core inflation index and improving PPI are signs of an economic recovery and a revival of demand, indicating that there is no foundation for sustained deflation or inflation in the medium to long term”. Indeed, it is difficult to agree with or refute the deflation narrative as trends are mixed. As Yu Hairong, Wang Liwei and Han Wei notes, China’s central bank defines deflation as “primarily a sustained negative growth in prices, a decreasing trend in the money supply, and often accompanied by economic recession.” Hence, on the one hand, the negative PPI, depressed property and stock markets and high debt levels are supportive of the deflation hypothesis. On the other hand, the positive CPI, real GDP growth above 5% and M2 growth of 9.7% contradicts the deflation claims. 

There is a marked difference though between how deflation is unfolding in China as compared with Japan. Japan’s deflation resulted from a severe asset price collapse that severely impaired corporate and financial balance sheets. Japan’s problem wasn’t deflation but risk aversion. Why Japanese households and corporations didn’t re-leverage long after their balance sheets were repaired is the real question. Though China’s property and equity markets have fallen, yet the extent of balance sheet impairment appears limited. Nonetheless, China’s economic woes are widespread. China needs to ride through this difficult period where geopolitical decoupling and an industry fall-out (from overcapacity) is resulting in severe price competition, firm closures, revenue shortfalls, and job losses all of which have a deflationary impact.

Another difference is that Japan’s domestic market was protected and domestic consumer prices were. Hence, deflation was prolonged because consumer prices are sticky and it took a long time for Japanese prices to finally converge with global levels. In contrast, Chinese consumer prices are relatively cheap and its markets are also relatively open (compared to Japan) to imports. This positions China’s deflation as being closer to the 1930s Great Depression variety than with Japan’s Lost Decades. Ironically, this means China could be susceptible to a more severe form of deflation than the benign deflation suffered by Japan. However, the Lost Decades was local and last three decades. In contrast, the Great Depression was global and characterised by beggar-thy-neighbour tariffs and trade protectionism but it lasted less than a decade before being interrupted by World War 2. We could be heading in the latter direction.

Western-leaning economists argue China should be bold and adopt bazooka stimulus to counter deflationary forces. China continues to ignore this advice, preferring instead to fine-tune their policy responses. Of course, there are risks that the disparate deflationary forces in China’s economy could suddenly converge into a centrifugal force that triggers debt dynamics and entrench deflation. For example, Lianhe Zaobao notes a 15.9% y-o-y decline in personal income taxes in January and February promoted netizens to comment: “With falling property prices, stock prices, income, bonuses and prices of collectibles, as well as financial storms, the middle class is really facing massive blows from all around…Before the idea came up that the middle class is returning to poverty, the so-called three-piece death kit to deplete the middle class’ wealth are: a housing loan amounting to nearly 10 million RMB; a spouse without a job; and two children who attend international school.  The three-piece death kit has now been upgraded into a five-piece return-to-poverty kit for the middle class. The poverty traps include: making an impulse investment to start a business; emptying wealth and assets to buy a house; getting an elite education for their children; being someone’s guarantor; and blindly investing and managing finances”.

My view is that there is unnecessary bias against deflation in economic theory. This bias was shaped by the 1930 depression when economies were physical and rigid. Debt deflation economics are well understood today. The modern economy is characterised by intangibility and flexibility, and are backstopped by central bank balance sheets. In the modern economy, mild deflation and a strong currency benefits consumers[12], wage earners and retirees and provides a good counter-balance to Baumol’s cost disease. In this context, China’s policy-makers are thought to value price stability above growth. China’s policy-makers intervened pre-emptively to puncture their asset price bubbles, discipline local government financing, and have attempted to manage the deflationary after-shocks from foreclosures, illiquidity and bankruptcies for several years. In this regard, the industry fallout from excess capacity is a potential source of additional deflationary pressure for China.

The question that should be asked though is who is better off? China and Japan that is facing deflationary pressure; or Europe and US that is facing inflationary pressure. I think mild inflation and deflation can be considered as constituting price stability. China’s citizens and industries benefit from lower costs. The challenge is really price volatility – high and entrenched inflation or deflation rates. China and Japan’s deflation has been mild and the threat they pose is manageable. If their economy suffers problems, it is probably due to other reasons. In contrast, volatile inflation in the Western economies poses a greater threat to macroeconomic stability.

There are global implications arising from China’s deflation. Of course, prolonged deflation implies China will lose the nominal GDP race against US and their economy could even contract, as it did for Japan. There is a view that China is exporting deflation, aggravated by a weak yuan. Some argue this is positive as it helps reduce inflationary pressures in the West. But in today’s geopolitical climate, deflation and a weak yuan is perceived as aiding China to export its excess capacity which is threatening the viability of Western manufacturing. If China does not voluntarily restrain itself as Japan did, then the West is likely to react with trade barriers. The escalation in beggar-thy-neighbour policies could turn deflation into a global depression. In comparison, Japan’s deflation resulted in the export of liquidity, and combined with China’s accumulation of USD FX reserves, both countries exported significant liquidity to foster a global environment of low interest rates and low inflation. Today, China and Japan’s (to a lesser degree now) deflationary environment stand in stark contrast with the inflationary environment in US and Europe. The situation is puzzling when one considers that in deflation-prone China, money supply growth continue to be positive. In contrast, in inflation-prone US and Europe, money supply seems to be contracting. Perhaps the data trends have been distorted by the huge pandemic stimulus in the West and the underlying trends will be more apparent once the normalisation of monetary policy is complete.

  • The debate on generational change and transformation

Han Feizi notes “analysts tend to attribute Japan’s economic malaise to financial mismanagement with demographics looming in the background like a chronic disease. It’s more complicated than that. Japan never recovered financially, economically or socially after the US kicked its legs out from under it in the 1980s and 90s with the Plaza Accord, the evisceration of Toshiba and humiliating voluntary export quotas on cars. Mismanaging an asset bubble, shielding the service industry from competition and keeping zombie companies on life support certainly didn’t help. But given the Plaza Accord’s constraints on the yen and the neutering of leading industrial giants, it’s not surprising that Japan retreated into a pot much smaller than the one it had occupied and once imagined for itself. Japan suffered from nothing less than a loss of vitality as a bonsai’ed people dealt with lowered ambition by withdrawing from society (hikikomori), becoming herbivores (celibate) and marrying their kawaii anime pillowcases. Despite dipping into the junior college bench and educating a larger proportion of the population, Japan just could not offset its declining and demoralized youth by making them higher-quality workers. And as such, the country fell precipitously down the science, technology and industrial league tables”.

William Pesek notes “roughly 12 years after China eclipsed Japan in GDP terms, President Xi Jinping’s economy is set to dominate Asian tech as Japan once did. Japan, meanwhile, trails its peers in producing “unicorn” tech start-ups…it is bureaucratic fiefdoms unwilling to embrace change. Generation after generation of politicians refused to upend this status quo. As leaders avoid disruption, CEOs lack confidence that the economy will be more vibrant 10 years down the road. The result is timid investment trends, sluggish income growth and a dearth of risk-taking”. Tan Kong Yam[13] notes “when the bubble burst in Japan, it only had mature industries such as automobile, consumer electronics and steel. It completely missed the Internet revolution of the 1990s…Meanwhile, China now holds key leadership positions in emerging industries – such as electric vehicles, batteries, clean energy and artificial intelligence – which would be the key points for growth and pillar industries in the coming two decades”.

In this context, Nire Shūhei[14] is worried that “a bunch of old men in suits” dominate politics and will “guide the economy forward in this challenging environment…This sorry state of affairs means that most of our big companies no longer have the dynamism that would allow them to adapt” and asked whether Japanese companies are “now doomed to inevitable decline”. The decline is evident in Japan’s auto industry which is facing difficulty coping with “the new wave of electric vehicles…any attempt to adapt to these changes is hampered by objections about what will happen to the suppliers and other business partners under the wider company umbrella”.

Noah Smith points out “Japan needs to abandon its do everything in-house strategy” as well as address “the root cause of its long decades of economic underperformance. That root cause is Japan’s broken corporate culture…Encourage mid-career hiring of managers from other companies, instead of promoting everyone in-house…Encourage employees to do some of their work from home (hybrid work)…Stop using government money to bail out failed companies…Japan’s traditional lifetime employment system keeps good ideas siloed within individual firms, preventing them from benefitting Japan Inc at large”.

Richard Katz[15] notes during Japan’s high-growth from 1953 to 1973, “the birth rate of new companies…was a high 12%, while the death rate was 5%. But when the economic growth rate dropped by half following the 1973 oil shock and then to only 1% after the bursting of the stock market and real estate bubble in 1989, Japan’s leaders slowed down creative destruction in the name of social stability, entrenching a problem that they are still trying to solve today”. Rather than reform the private-sector safety net, the Liberal Democratic Party (LDP)…Instead, they made a worker’s current job at his current company the prime backup. That led to voter pressure on politicians to prop up even the most moribund firms. The government even subsidized wages to maintain redundant workers, while making it harder for new challengers to replace even inferior incumbents. Consequently, the birth and death rate of companies has plunged and is now one of the lowest among 27 rich countries”.

He adds “one of the most serious problems facing Japan is the division of the labor force into regular full-time employees and non-regular part-time and temporary workers…less money and fewer benefits. As a result of corporate cost-cutting, the non-regular share of Japan’s workforce has risen to almost 40%, up from 15% in the 1980s. While regular workers earn 2,500 yen (US$17.36) per hour, non-regulars receive 1,660 yen and part-timers only 1,050 yen. In addition to creating a class system, this contributes to demographic decline…59% of Japanese men 30–34 with regular jobs are married or have been and by age 39, the share rises to 70%. Among non-regulars aged 30–34, it’s just 22%”.

Han Feizi argues “the underappreciated cause of Japan’s lost decades is the degradation of its human capital. In 2022, Japanese universities produced as many science and engineering grads as they did in 1990, despite a doubling of enrollment rates at four-year universities. Starting in the mid-90s, as the youth population dwindled, four-year universities in Japan started to dip into the junior college bench, which enrolled 14% of Japanese post-secondary students in 1995. By 2013, junior college enrollment fell to 5% while four-year college enrollment increased from 31% to 55% in the same period. At the same time, those choosing to study science and engineering fell from 24.5% in 1971 to 18.1% in 2016 as Japanese STEM students gravitated towards medicine, in which enrollment saw a threefold increase in percentage terms. The combined effect of dipping deep into the bench and losing STEM students to fields like medicine can only have lowered the quality of scientists and engineers that Japan did manage to produce. With college graduates having plateaued in the 1970s, Japan is long past the era where its universities are adding educated employees to the workforce. Japan, like the rest of the developed world, is now in replacement mode and, given the dwindling youth population, is forced to graduate students of ever-decreasing ability”.

Han Feizi explains “Japan failed to upgrade the quality of its workforce after the Plaza Accord; it was simply outcompeted by China and South Korea, both of which did. Analysts who obsess over Chinese property developers’ balance sheets, investment/consumption balances and local government debt are missing the forest from the trees….China, like Japan, South Korea or any other economy, has always been a human capital story. It’s people all the way down”. “China, in contrast, has not yet plateaued in enrolling students in higher education. From single-digit university enrollment rates at the turn of the century, in 2022 China enrolled 34% of its 18-year-old age cohort into four-year degree programs and 29% into junior colleges. If college enrollment plateaued today, China’s college-educated workforce will increase fourfold over the next 30 years. The proportion of Chinese students majoring in science and engineering at four-year universities was 41% in 2015, more than twice Japan’s level. At the junior college tier, 43% of students were studying technical fields (and 13% in healthcare.)”. “China’s human capital upgrade is just beginning to hit its stride while, in the 1990s, Japan’s was peaking. China’s college-educated workforce will not peak for another 30 years. To prevent education from eating its young, China recently outlawed the entire for-profit tutoring industry. In the next two to three decades, China will be flooding its workforce with newly minted scientists and engineers to staff companies you never heard of just a short while ago – CATL, BYD, DJI, miHoYo, BOE”.

Han Feizi notes “South Korea, on the other hand, with a smaller population and similar demographic profile, has heroically outcompeted Japan in semiconductors, consumer electronics, chemicals and shipbuilding. The country’s contribution to global scientific papers and patents has continued to increase and its per capita GDP surpassed that of Japan in 2018. In the past two decades, South Korean youths have become the world’s most educated with over 70% of the population between 25 and 34 having completed tertiary education (versus 50-60% in other highly educated OECD countries)…Even as birthrates plummeted, South Korea was able to increase patents filed as well as scientific papers published, more or less matching Japan with less than half the population. Similarly, South Korea has maintained its percentage of manufacturing value-added even as the China juggernaut swallowed up market share from everyone else. The terrifying secret behind South Korea’s success is the nation’s savage dedication to education. For the past two decades, South Korea’s gross enrollment of its 18-year-old age cohort in higher education has been around 100% with some years exceeding 100%. What this means is that South Korea has run out of 18-year-olds and is enrolling older students in universities to produce the workers it needs…While seemingly succeeding, the cure may be exacerbating the disease. Korean youth have an educational experience that reformers liken to child abuse. Koreans appear to have taken education to whole new levels of Asian madness. For-profit cram schools (hagwons) were established decades ago for remedial test preparation. Today, they have taken over the education system, enrolling the majority of Korea’s five-year-olds. The upshot of outrunning demographic decline through intense education, which South Korea has apparently succeeded in doing, is that an overworked and educationally ground-down population are now having even fewer children. South Korea’s 2023 fertility rate per woman was a catastrophic 0.72 (with 2.1 necessary to maintain current levels of population). What this all means is that while South Korea has outrun Japanification for the time being, the eventual reckoning threatens to be catastrophic”.

  • Summary

Overall, I think the term “structural reforms” is often used too loosely We need to think more carefully about what the objectives of the structural reforms should be before making recommendations them. Japan did not adopt a wholesale approach to corporate reforms, did not properly manage internationalisation, digital change and generational change. As a result, Japan failed to make their domestic economy globally competitive while its firms allowed themselves to be gradually displaced from the frontier of business disruption.

If Japan reforms too little, then China reforms too much and too often. In contrast to Japan’s timidity, Chinese reforms are intrusive and frequent – covering regulation of  “undesirable” economic and social behaviour, platform and cultural trends, corruption and speculation. China ensures all policies are aligned with its long-term vision and seldom make compromises that deviates from its core goals. As a result of its “whole-of-society” approach, China is continuously changing at an unprecedented speed and scale. The recent decade has seen the emergence of world-class Chinese companies and disruptive business models.

  • The debate on geopolitics

When Japan became No.2, it became the first Asian country to challenge the US in modern history. However, expectations that Japan would overtake the US proved unrealistic. Japan had a smaller population and domestic market and was an insulated economy with minimal foreign presence. The US exerted pressure on Japan on a number of fronts. In 1994, US had a 46% share of the global economy and Japan was in no position to resist US pressure. In hindsight, the fallacy that Japan could dislodge US became evident and Japan had over-achieved to become World No.2.

Huijian Wu notes “in 1985, Japan overtook the United States as the world’s largest creditor, and products made in Japan flooded the world. The frenzied expansion of Japanese capital caused Americans to exclaim Japan will take over America in peace!” This prompted the US to assert pressure on the Japanese government to agree to appreciate the yen (Plaza Accord). “In 1986…the Japan-United States Semiconductor Agreement, in which Japan, on the one hand, abolished its own production capacity and, on the other hand, opened up the Japanese semiconductor market, and from then on, Japan’s globally dominant semiconductor industry took the road of no return. In 1989, the US again launched a 301 investigation into Japan’s government procurement of satellites, with the result that Japan had to abandon its plans to develop its own satellites and the development of the space industry came to a standstill”. “Japan is dependent on the US because of its comprehensive power. Japan is politically dependent on the US for protection, economically dependent on the US market, and financially unable to get rid of the US dollar. When the US could not win the game, they used off-field forces, such as foreign exchange, laws, standards, rules, etc. Hegemonic tactics were used to bring the Japanese to their knees. This approach has been tried and tested and to this day Japan is still in this noose and cannot extricate itself”. He argues US is relying on the same old tricks they “used against Japan back then – using US domestic law, Trade 301, to attack China…accusing China of stealing US technology, starting to impose restrictions on China’s high-tech industries, forcing China to come to the negotiating table with high tariff penalties, and using this to force China to give up the development of high-tech industries”.

Japan never recovered from caving in to US pressure. Eventually, Japan lost ground globally – falling from No.2 to No.4 and will probably be No. 5 by the end of this decade. Its share of global GDP has shrunk from 18% to 5%. On the other hand, Japan’s economic sacrifices made it possible for peaceful co-existence among developed economies and laid the groundwork for hyper-globalisation. In turn, global growth helped to keep Japan’s depression relatively benign.

In this regard, the decline of Japan was also largely due to the rise of China which replaced it as World No.2. Unlike Japan, China remained ideologically independent and is considered a security threat to the US. Unlike Japan which never surpassed the US, China overtook the US in PPP terms in 2016 and its 2023 PPP is estimated at 18.8 trillion; already 22% higher than the US. It has four times the population of US, a large foreign business presence in its market, the largest and most competitive market in the world and a large Chinese diaspora to support its international expansion. It seemed a formality China would eventually overtake the US in nominal GDP terms to become the World No.1.

As the geopolitical conflict intensifies, China is now coming under pressure. Ye Xie thinks China faces “greater geopolitical risks. While Japan also had economic frictions with the US in the 1990s, the conflict was limited to the trade sector. In China’s case, a full-blown decoupling with the West would mean the nation could only export to poorer economies”.

However, the global landscape is much changed and China is much better positioned than Japan to take on the US. The US share of the global economy has shrunk from 46% in 1994 to 26% today. According to Bruno De Conti, Pedro Rossi, Arthur Welle and Clara Saliba, the “G7 countries’ combined share of world GDP fell by one fifth – from 57 percent (in 1990) to 37 percent (in 2022)…At the time of the creation of the G20 in 1999, the participation of global South countries in the group’s total industrial production was around 10 percent. From 2005 onwards this share began to grow rapidly, reaching almost 50 percent in 2021”.

On its own, China’s domestic market is generally larger than the US. As Richard Baldwin notes China’s gross globalisation ratio (GGR) “in manufacturing…almost doubling…between 1999 and 2004…it is probably why so many think of China as an economy that is incredibly dependent on exports. But…since 2004…production grows faster than exports, implying that domestic sales were becoming relatively more important, compared to export sales – even though domestic and foreign sales were both booming throughout the high-growth episode. This dispels the myth that China’s success can be entirely attributed to exports. From around 2004, China increasingly became its own best customer. The takeaway is simple: China’s openness, as measured by the GGR, has fallen rapidly. By 2020 it was only slightly more dependent on export sales than it was 1995”.

At the corporate level, Japanese manufacturers were the first non-Western firms to break the barrier to successfully challenge American and European manufacturers. Japan’s global rise was led by local champions. Japanese products were cheap abroad but its domestic market was protected and expensive. While Japanese firms had innovative business models such as zero defect and lean manufacturing, the corporate culture was insular. China’s global rise was initially led by foreign firms that established their supply chains in China. It is only this decade that Chinese firms finally emerged as world-class competitors with disruptive business models. China’s domestic market is considered one of the largest and most competitive in the world – with low prices and a wide range of domestic and international offerings. Chinese firms are displacing Western firms in both the domestic and global markets at a rapid pace. As a result, many Western countries are considering imposing tariffs, tightening security reviews over technology and other assets, and gearing up their industrialisation plans. Western MNCs are de-risking and reshoring production away from China. However, Chinese MNCs are mitigating decoupling losses  by moving quickly up the value-add curve, developing brands and aggressively expanding across global markets.

While China and Japan powered their way to World No.2 through their strengths in production, trade and technology, both were handicapped by a relatively under-developed presence in global finance. In the 1990s, Japan tried to attract global financial players but they found Tokyo too costly and unprofitable. Though Japan’s banks were among the largest in the world then, the attempts to build global financial franchises and internationalise the yen had limited success. Back home, after its property and stockmarket collapsed, Japan resisted pressures from the global investment community to resolve its bad loans through fire-sale FDI. At the moment, China is under pressure as the West is withdrawing its capital and putting the yuan under pressure. China has to develop the financial intermediaries and global networks in tandem with its de-dollarisation strategies to neutralise the US advantage in finance.  

Japan’s revival?

Is the Japanese economy finally awakening from its deflationary slumber? Japan’s stockmarket finally breached its all-time high of several decades ago. Wages and inflation finally seems to have picked up pace. Tyler Durden notes “the Bank of Japan hiked interest rates…for the first time since 2007. This move ends the world’s last negative interest rate policy… Additionally, the bank has abandoned its yield curve control policy. The BOJ will continue to purchase JGBs with broadly the same amount as before, but buying of ETFs and J-REITs has apparently been scrapped (while laying out a plan to scrap corporate debt and commercial paper buying)”.

Grace Shao notes “as geopolitical tensions remain high, U.S. capital has been moving out of China and into Japan. President Joe Biden’s restrictions on certain U.S. investments in China’s biotech, AI, and any sectors that could be deemed as “civil-military fusion” have caused concerns for many global financers investing in the second largest economy since mid-2023. The U.S. government’s executive orders to restrict outward investment into Chinese advanced technology and sanctions around Chinese tech companies have created considerable worries for U.S. investors looking at the market. Thus we’ve seen Sequoia spinning off its China arm, Hillhouse repositioning itself as a APAC fund, and TPG not investing in China anymore”. In addition, global investors seem to have lost patience in waiting out the stockmarket downturn. “Many private equity firms and hedge funds finally threw in the towel and shut down operations over the last year. A number of China-focused hedge funds in Asia dropped significantly, with many shutting down operations and leaving the Greater China market”.

Grace Shao notes that “investors scorched by the grim Chinese market are picking Japan and India as top choices – India as the next growth story and Japan for its economic and capital market reforms. With all this in mind, Japan-focused funds doubled in the last year, with significant number of APAC funds pivoting to multi-market strategies…The TOPIX, an index of Japanese stocks, is projected to rise about 13 percent to 2650 by the end of 2024, according to Goldman Sachs. M&A activities in 2023 rose about 50 percent year-on-year…The Japanese equity market is forecast to rally in 2024, boosted by solid growth and stock market reform according to Goldman Sachs in a recent outlook memo”. In this regard she notes that investors understand “Japan’s capital market is mature and robust. The influx of capital to Japan has inspired regulators, businessmen, investors across the board. While foreign capital piles into Japan, the United States and Japan are using this opportunity to go beyond just solidifying business partnerships…upgrade the Japan-U.S. security alliance…The greenlight directly from the U.S. government on partnership with Japan across all sectors only makes its markets more attractive as a safe haven from geopolitical tensions. So while China’s global growth story is hitting a rough patch, in Asia, we’ve now officially entered the era of Japan’s revitalization”.

While Japan’s economy remains sluggish, Noah Smith thinks there are “some reasons to be optimistic about Japan’s economy in general. First, the country is finally taking its own defense seriously – defense spending surged from 5.4 trillion yen (US$35.9 billion) in 2022 to 7.95 trillion yen ($52.5 billion) in 2024. That’s still only about 1.5% of GDP but the rapid increase is pretty stunning. Defense spending will stimulate manufacturing, but will also give Japan the chance to build its own military-related tech industries…Second, Japan is bringing in large numbers of foreign workers to ease its labor shortage…Finally, the big international push to de-risk from China should end up benefiting Japan…focus on industrial policy, which was a Japanese strength in the past, and which I think could serve it well again” and to leverage on FDI to reclaim Japan’s position in the electronics supply chain”. “Luckily, Japan has a ton of natural advantages that make it the perfect place to build chip fabs…The first four reasons are: The weak yen (and low interest rates), A lot of high-quality semiconductor tools and materials companies that still exist in Japan, A highly skilled semiconductor workforce that will work for relatively low wages, Pro-development land use policy and few NIMBY barriers. At this point, building chips in Japan is almost an arbitrage. I also added government support and entrepreneurs’ hunger and ambition as the fifth and sixth advantages”.

Scott Foster notes in Richard Katz’s new book, The contest for Japan’s economic future: Entrepreneurs vs. corporate giants, he declares that: “For the first time in a generation, Japan has the potential to rewrite its story. On the surface, the economy seems intractably stagnant and politics disappointingly unresponsive. Beneath the surface, reason for hope arises from six megatrends that add up to a tectonic shift in civil society. These include generational shifts in all sorts of attitudes, technological changes that alter the power balance between incumbents and newcomers, shifts in gender relations, the ramifications of the demographic crunch, the stimulative effects of globalization, and the political stresses induced by low economic growth”. Richard Katz notes “out of Japan’s 55 billionaires in 2021, 11 had founded a company within the previous 25 years. This is the biggest infusion of new high-growth companies in decades”. The new billionaires are “young, cosmopolitan, and unconventional in their thinking. On average, they started their companies at age 30 and were billionaires by age 42. Many have lived abroad, studied at an overseas university, and/or worked for a foreign company. Most importantly, they had the independence of mind to see gaps in the market – and ways to fill them – to which executives at incumbent firms were blind…simply use the latest technology to revolutionize existing prosaic businesses”.

There is a perverse geopolitical logic wrapped around the Japanese revival story. The first is that because China faces Japanification risks, investors should therefore invest in Japan. The second is that if the Japanese “recovery” finally materialises, it would have had little to do with the advice that Japan received over past decades, and with Abenomics. As is now becoming evident, the economic advice dished out to Japan is mainly motivated by the need to avoid geopolitical conflict by mounting a direct challenge to US economic supremacy.

This leads to the third point that Japan’s revival is actually based on the return of a national assertiveness that has gone missing for decades; in effect a revival of Japan Inc.. Japan is now encouraged to reindustrialise and remilitarise itself to confront a rising China. Japan is reviving itself by rebuilding indigenous technology capabilities through Western alliances and by shifting investments from China to new markets like India and Vietnam. In other words, Japan is reviving its economy by adopting China’s policies. This implies Japan’s biggest policy mistake was its retreat from industry and technology to mollify American sensitivities.

However, investors may have run ahead of themselves on Japan’s economic revival.  

Japan continues to be trapped by the current global landscape and past fiscal and monetary policies. As is the case for developed economies, the quest to reindustrialise is an uncertain journey. Despite their established presence, Japanese MNCs are finding themselves being pushed from the center to the fringe in China and the Global South markets. Can Japanese MNCs re-discover their can-do attitude and reinvent themselves to re-establish their presence in crowded global markets like in semiconductors, electrical products and cars or challenge China in the new industries?

At this stage, can Japan exit from its policy combination of fiscal deficit and QE stimulus without mishap? Wolf Richter notes “the yen dropped to ¥154.7 to the USD, a 34-year low, despite endless copy-and-paste jawboning by Japanese authorities and some market intervention…The yen has plunged by 32% against the USD since 2021 when other central banks started moving away from QE…and it has collapsed by 50% since 2012 when…Shinzo Abe implemented his economic policies (“Abenomics”) of fiscal profligacy funded by money printing, huge amounts of money printing that was reinforced in 2016 by the institution of Yield Curve Control, which kept the 10-year yield near 0%”. “The BOJ has started to react in tiny baby steps, but there is nothing in these tiny baby steps that would stop the destruction of the yen – it’s still destroying the yen, but in slightly smaller increments”.

Analysing Japanification and China’s policy takeaways

Japanification is well analysed but never well understood. Japanification is a slow-burn disease and it took more than a decade before it was formally recognised. Japanification should be recognised for what it is – a unique economic experience rather an inevitable one. Japan was the only matured economy to suffer a prolonged deflationary environment during the globalisation heydays. Han Feizi points out “it’s just not true that every country that has followed the Japanese model has had to suffer long periods of painful economic adjustment – at least nothing approaching Japan’s malaise”.

Yet, many countries have been suspected of suffering from Japanification. Neil Shearing reminds us in 2019, “a frequent topic of discussion was our view that we’re witnessing the steady Japanification of Europe and, indeed, much of the developed world….as things stand, the parallels look strongest in Europe and, in particular, the euro-zone and Switzerland…But in general terms, the macro environment in the developed world over the next 2-3 years is likely to be one of mediocre growth, low inflation and very low interest rates”. These comparisons faded as inflation and interest rates rose in Europe.

In the US, Sean Williams notes it experienced its “first significant drop in M2 since the Great Depression”. “In July 2022, U.S. M2 money supply peaked at an all-time high of roughly $21.7 trillion…M2 stood at $20.78 trillion, as of January 2024…a year-over-year drop of 1.44% and an aggregate decline from the July 2022 peak of 4.21%”. “The caveat to the decline since July 2022 is that M2 expanded at a truly historic pace during the COVID-19 pandemic. Fiscal stimulus increased M2 by a record 26% on a year-over-year basis. Thus, a case could be made that a 4.21% retracement is merely a reversion to the mean”. “Then again, history has been incredibly unforgiving when M2 money supply has fallen by at least 2% on a year-over-year basis. According to research conducted by Reventure Consulting…there have only been five instances…where M2 has declined by at least 2%: 1878, 1893, 1921, 1931-1933, and July 2022 through at least January 2024. The previous four instances all coincided with deflationary depressions and double-digit unemployment rates…Since data reporting began in January 1973, there have only been three instances where commercial bank credit has pulled back at least 2% from its all-time high…In October 2001, during the dot-com bubble, commercial bank credit slipped a maximum of 2.09%. In March 2010, shortly after the Great Recession, commercial bank credit troughed at a 6.94% decline. In November 2023, commercial bank credit hit a peak drop of 2.07%”.

The moral of the story is that there are many shades of Japanification but in the end, all Japanification comparisons have come to naught. On this note, it is a puzzle why China has become the latest Japanification identification victim. Japanification is an economic disease (a mild and prolonged depression) associated with maturity. China is a middle-income country growing at a respectable 5% (if you believe it). The most crucial symptom of Japanification, in my view, is private sector balance sheet retrenchment. Here, the global trends are confusing. China’s money supply growth may be slowing but it is still positive despite a deflationary environment. On the other hand, Western economies are experiencing money supply contraction despite an inflationary environment.

In fact, it has been a mystery why massive fiscal and monetary stimulus never materialised into economic growth and inflation in Japan. The plausible answer lies in leakages. First, BOJ’s massive QE underpinned a carry trade that flooded the world with liquidity. Second, Japan’s export-led model was modified in work-arounds to evade Western sanctions and growth leaked into China and other Asian countries. Thus, Japan’s contribution to the rise of China is probably itself a major factor contributing to its Japanification.

It is probable China’s first policy-takeaway is not to follow Japan’s reckless fiscal spending, negative interest rates and QE-bazooka monetary policies. These policies did nothing to overcome Japan’s deflation and in fact left Japan trapped in a quagmire from which it cannot now exit without significant risks. The second takeaway is that fiscal and monetary policy cannot compensate for the consequences of geopolitical retreat. Who knows how Japan would have fared if they had defied the US on semiconductor technology. In any case, there is little space for China to retreat. Put another way, restructuring the domestic economy won’t matter as much if China doesn’t win the geopolitical industry, technology, trade and currency war.

William Pesek notes US Treasury Secretary Janet Yellen recently asked China to promote “balanced” economic growth amid US concerns about industrial overcapacity and to increase stimulus to reflate its economy. He suggests “Yellen’s comments echo those Washington directed at Japan in the mid-to-late 1990s…What Yellen is advocating is a strategy that Japan has been pursuing for 25-plus years with mediocre success”. “China must avoid this formula for economic mediocrity, no matter how much flack Xi’s inner circle gets from Yellen & Co”. Judging from recent events, “Yellen’s hopes that China will heed Washington please-reflate-immediately stance is a non-starter”. “President Xi Jinping’s team appears to favor…hyper-targeted liquidity infusions coupled with efforts to shift growth engines towards tech-driven future industries that increase disruption and productivity…The new program will channel one-year loans through 21 financial entities…to ramp up support for science and tech-oriented SMEs in both the early stage of development and the growth stage. It will prioritize enterprises with great potential to power China’s transformation and will finance the range of equipment renewal projects needed to accelerate digitalization and green initiatives across sectors”. In addition, Xi’s party unveiled a list of state-owned enterprises and conglomerates that will spearhead this fresh wave of future-oriented sectors…AI, neuroscience, nuclear fusion and quantum computing”. “A recent Bloomberg Economics study found that the contribution from the high-tech sector is on path to rival real estate by 2026. The high-tech sector has potential to become a much more significant source of growth…Tech is seen driving demand worth nearly 19% of GDP by 2026, up from 14.3% last year. The property sector drives demand worth just over 20% of GDP”.

The third takeaway is that China should address its financial sector weaknesses to insulate domestic economic stability from adversarial policies and global volatility. There is a suspicion the West exploited Japan’s financial vulnerabilities to knee-cap its economic ascendancy and that the same thing is happening to China today. China has been relatively disciplined and prioritised price and forex stability. William Pesek notes  PBOC has, so far, persisted with efforts “to revive the economy without massive stimulus” and that “China’s banking system is robust enough to withstand most shocks”. “The PBOC drew a line in the sand and defended the renminbi” and resisted a competitive devaluation despite weakness on the export front.  He notes “there are a few possible explanations for why China is putting a floor under the yuan. One is to reduce default risks among property developers servicing offshore debt. Another is to avoid fresh trade tensions with Washington. Beijing also wants to stanch the capital outflows now making global headlines”. Thus, “China is calming fears for the year ahead that it might engage in a race to the bottom on exchange rates…reassuring traders worried Beijing might chase the falling Japanese yen lower”. “An argument can be made that Xi’s real goal is staying focused on longer-term retooling, not short-term economic sugar highs”.

Indeed, the global financial landscape is massively changed from the Goldilocks era. The US is flexing its financial muscles by maintaining high US interest rates, a strong dollar, the overhanging threat of sanctions, moral suasion (to divest from China) and exploiting China’s government thorny relationship with global investors. China is not a helpless victim either. China is actively pursuing de-dollarisation and promoting internationalisation of the yuan on alternative payments infrastructure to unshackle the US grip on the global financial system. China no longer invests much of its surpluses in the West (which are unwelcomed anyway) and is quickly building bilateral interdependencies with the Global South. China needs to do much better than Japan in overcoming its global finance handicaps. China needs to broaden and deepen its international financial ecosystem – in areas such as fund management, middle and back-office management and information intermediation – to support increasing the international liquidity and leverage of the yuan. Most importantly, it needs to strengthen the credibility and “safety” of yuan assets by strengthening disclosures, governance and debt resolution processes.


The cries of “Japanification of China” is probably a forewarning of the looming, bruising confrontation between the West and its latest Asian challenger. China’s share of global GDP has reached the same peak of 18% previously achieved by Japan. But history is unlikely to replicate the previous script as it is evident China is unlikely to follow Japan’s path of “cooperation”; having studied its fate.

Frankly, China and the West are headed for a fight. Western lectures on over-capacity are falling on deaf ears in China. China is sticking to its modernisation strategy leveraging on its cost competitiveness, speed, scale and business model disruption to overwhelm Western competitors. The West is taking containment up another notch to put the squeeze on China and to expose its domestic vulnerabilities and problems. Nonetheless, the China model seems to have struck a chord with developing economies that are eagerly embracing their concepts of technology leapfrogging (digitalisation, 5G and clean energy), diversification in bilateral relationships away from the West and de-dollarisation. China is thus reconstructing its global interdependencies by building new relationships with the Global South and seems to be preparing to abandon, if the need arises, its traditional relationships with the West.

The monetary war is quietly being fought alongside the economic war. China, like Japan before, is handicapped in the currency game. Its level of financialisation is relatively low. This hampers its efforts to internationalise its currency. This is manifested in terms of the disparity between the nominal and PPP GDP. To some extent, China’s deflation arises because it is unable to increase leverage of the yuan without undermining the exchange rate. Despite its high fiscal debt, the US has been able to leverage on the hegemonic position of the dollar and maintained interest rates to put pressure on the yuan. The PBOC faces a dilemma. If it tightens capital controls to defend the yuan and maintain domestic financial stability, how is it going to move forward on de-dollarisation. Thus, there seems to be a contest to see the US maintaining high interest rates despite its fiscal debt compounds versus China’s ability to maintain low interest rates while defending the yuan against the Western attacks. These are domestic contradictions and it would be interesting to see whether the US or China gives up first.

Overall, China is taking the road that Japan assiduously avoided. It is unfortunate there doesn’t seem to be much space for either side to retreat. The West has much to lose if China continues to expand its global dominance of manufacturing. On its part, China cannot rely on “friendly” relations with the West. Even if China makes concessions, it will only end up being subject to further punitive actions. Thus China is building up its framework for retaliation. Unsurprisingly, the global economy is starting to fragment into a US- Europe-North Asia bloc with India being lined up to replace China’s role. But they are facing off not only China but an increasingly independent rest of the world. The “rules-based order” is breaking down into a messy multipolarity. This will lead to a global reset.


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[1] See Chen Jing, and Nicholas Spiro

[2] See “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”.

[3] See Robin Wigglesworth.

[4] See Robin Wigglesworth.

[5] See Robin Wigglesworth.

[6] See Ye Xie.

[7] See Takino Yūsaku.

[8] See John Kemp.

[9] See Robin Wigglesworth.

[10] See Yu Hairong, Wang Liwei and Han Wei.

[11] See Yu Hairong, Wang Liwei and Han Wei.

[12] See Han Feizi “Behold China’s consumer paradise”.

[13] See Chen Jing.

[14] See Takino Yūsaku.

[15] See Scott Foster.