China in Transition

The Chinese Economy After the Burst of the Bubble
- Lessons to be learned from Japan

Chi Hung KWAN
Consulting Fellow, RIETI

Amid a virtuous circle in which investment and economic growth serve to boost each other, it appears that China is now experiencing an economic bubble, as can be seen by soaring real estate prices. However, triggered by recent moves by authorities to rein in the economy, we can expect to see things turn into a vicious circle where investment and asset prices falling dampen economic growth. Once the bubble bursts, China's corporate sector will likely face the need to reduce employment, production capacity and debts, just as Japan did in the 1990s.

In Japan, many companies have adopted a de facto lifetime employment system, which has made employment adjustment a time-consuming affair. However, this also made it possible to avoid a sharp rise in unemployment even when the recession worsened. In contrast, it is far easier to fire workers in China, and unemployment can be expected to surge once the economy starts to decelerate. At present, China has about 100 million migrant workers who come mainly from the rural areas to the cities and from inland regions to the coastal regions. Since their remittances to their families are a key source of income for regions that have been left behind from the economic growth experienced by the rest of the nation, maintaining employment is an important issue for authorities that not only stops at being a simple economic problem but also one on which the stability of society as a whole depends.

In addition, much of the investment undertaken in recent years has been based on the presumption that China's rapid pace of economic growth will continue. However, once the economy slows down, sales will become sluggish and companies will find themselves with excessive capacity. Especially, construction-related areas such as steel, cement and aluminum, which are already viewed as being overheated, will encounter serious problems. There is also a high likelihood that the automobile industry too will face escessive capacity. Japanese automakers such as Toyota Motor Corp., as well as other global carmakers, have already begun making huge investments in China. What is more, Chinese firms that have never before tried their hand at making automobiles are striving to enter the market. Should deflation progress amid sluggish domestic demand, Chinese companies will have no choice but to focus on exports. However, China is already the largest source of U.S. trade surplus, and a further rise in exports would aggravate trade frictions with Washington.

Furthermore, as the performance of borrower firms worsens, banks will see their nonperforming loans balloon further, leading to a serious credit crunch. Some 40% of investment in the so-called "overheating areas" of steel, cement and aluminum comes from banks. When the time for adjustment comes, large-scale corporate restructuring including bankruptcies would be come inevitable, and banks will have no choice but to shoulder a part of that bill. The level of nonperforming loans held by China's banks is the worst in the world, and the situation will worsen once the bubble bursts ( table ). In order to avert a financial crisis, like Japn has done before it, the Chinese government will have no choice but to inject public funds into the banking sector to help it dispose of nonperforming loans. However, this will not lead to a comprehensive solution, because even though the infusion of public funds can temporarily reduce nonperforming loans, with state-owned banks and the state-owned enterprises that comprise their core borrower base lacking corporate governance, it cannot keep fresh nonperforming loans from popping up. China's four major state-owned banks plan to go public in overseas stock markets in the near future, but this will be difficult to realize if it happens at the same time that the nonperforming loan situation worsens. In Japan's case, some banks, such as the Long-Term Credit Bank of Japan (the current Shinsei Bank) and Resona Bank, failed to procure funds from capital markets by themselves and were forced to come under government control.

It took Japan more than a decade to resolve the issue of the "three excesses" in employment, equipment and debt. China has little time left to avert this Japan-style crisis.

Table: Non-performing loans of China's banking system (end of 2003) Table: Non-Performing Loans of China's Banking System (End of 2003)

(Note)The four major state-owned commercial banks are the Industrial and Commercial Bank of China, the Bank of China, the Agricultural Bank of China and the Construction Bank of China.

(Source)China Banking Regulatory Commission, January 2004.

June 22, 2004

June 22, 2004