China in Transition

Two Bubbles: Comparing China today with Japan in the late 1980s

Chi Hung KWAN
Consulting Fellow, RIETI

The Japanese economy experienced the emergence of an asset bubble in the late 1980s, which was followed by a long-term slump after its burst in 1990. A bubble is also forming in China's real estate market today, and how it will develop is attracting wide attention. Here, I will identify the similarities and differences between the two episodes and discuss the lessons China should learn from Japan's experience.

Similar factors leading to the two bubbles

Comparing China at the present with Japan during the bubble period, the following similarities can be noted.

First, as in Japan during the late 1980s, expansionary macroeconomic policies taken by the government in China today to achieve growth above the potential growth rate, which has fallen significantly on the back of labor shortages, is causing an asset bubble.

Also, liquidity has expanded as a result of the authorities actively intervening in the foreign exchange market to curb the rise in exchange rates. In Japan, the yen appreciated sharply following the Plaza Accord in 1985. In the wake of the conclusion of the Louvre Accord in February 1987, which sought to stabilize the U.S. dollar among the G7 member countries based on the recognition that the goal of correcting the strong dollar had been achieved, the Bank of Japan began to conduct a large-scale dollar-buying intervention. Together with monetary easing, this boosted liquidity which in turn fueled the asset bubble. In China, the market intervention undertaken to curb the rise in the yuan also has become a factor in expanding liquidity and triggering rising real estate prices.

In addition, apart from conventional bank lending funded by bank deposits, shadow banking is used as a way to get around the regulations of the authorities. In Japan during the bubble period, significant property-related lending was provided through non-banks such as jusen, or housing loan companies, that were beyond the reach of the authorities' supervision. This accelerated the ballooning of the real estate bubble and aggravated the bad debt problem after the bubble burst. In today's China, banks and trust companies are also pouring some of the funds they have raised by selling wealth management products and trust products, respectively, into the real estate market.

Lastly, although the prices of assets (real estate and stocks in the case of Japan, while real estate only in the case of China) are rising significantly, inflation has remained relatively low. This delays the shift to a tighter monetary policy.

Differences from Japan that are expected to attenuate the risks

On the other hands, there are many differences between China today and Japan in the late 1980s.

First, in Japan during the bubble period, as lending by banks to non-banks such as housing loan companies was part of their balance sheets, the loans would become non-performing if they went sour. In contrast, in today's China, most shadow banking products are separated from banks' balance sheets, and banks are not obliged, in principle, to compensate their customers for losses even if these products default.

Also, while most banks in Japan are private-sector companies, banks in China are mostly state-owned. Therefore, Chinese banks are expected to have the support of the government in times of emergency.

In addition, by the time of the bubble, Japan had already moved to the floating exchange rate system, and capital movements had been liberalized to a large extent. In contrast, the exchange rate of the yuan now is still managed strictly by the authorities, and capital movements are tightly restricted. As a result, the yuan is unlikely to become a target of speculation, and the destabilization of the financial market through major capital movements can be avoided.

Lastly, the two countries are at very different stages of economic development. Japan during the 1990s when the bubble burst was already a mature, developed economy. In contrast, China is still an emerging industrial nation. Even though the potential growth rate of China is lower than it was, by making use of the latecomer advantage, moderate growth of 6%-7% looks likely to be maintained for the foreseeable future. In particular, the expected advance of urbanization will underpin not only real estate investment but also overall economic growth.

Lessons China should learn from Japan

These differences provide favorable conditions for China to avert an economic crisis and a long-term economic slump that could result from the bursting of the bubble. In addition, learning from Japan's monetary policy failures should help China avoid falling into the same rut.

First, given that fluctuations in asset prices may destabilize the financial system through an increase in the non-performing loans of banks, etc., the authorities should monitor the movements of not only the price level based on the consumer price index (CPI) but also stock and property prices when formulating monetary policy.

Also, the expansion of the bubble entails an increase in credit. The authorities need to pay attention not only to the quantitative growth of credit, but also to changes in the composition of lending, particularly the share of property-related lending. Furthermore, the authorities should strengthen the supervision of shadow banking, in addition to banks.

Moreover, the authorities should adopt a forward-looking stance of monetary policy by identifying and coping with the risks inherent in the economy while they are still in the potential stage.

Lastly, if the central bank tries to emphasize the stability of exchange rates, market intervention will be necessary, significantly limiting the independence of monetary policy. To stabilize the economy amid increasing mobility of capital across national borders, the central bank should enhance the independence of monetary policy by allowing exchange rates to move more flexibly.

The original text in Japanese was posted on May 8, 2014.

May 8, 2014