Déjà Vu All Over Again
This weekend I was leafing through my copy of The Ministry, a 1997 book by Peter Hartcher about Japan’s Ministry of Finance and the role it played in the 1980s bubble and its “lost decade” aftermath, and was struck by several passages that called to mind what has been happening more recently in China’s economy. My intention here isn’t to offer a rock-solid case that China is following precisely in Japan’s footsteps — for those who are interested, here are two good articles on that question, pro and con. Nevertheless, these descriptions of what went wrong in Japan gave me a disturbing sense of déjà vu, and offer a thought-provoking historical backdrop for anyone trying to assess the consequences of China’s stimulus-driven boom.
The author quotes Isao Kubota, an official in the Ministry of Finance’s Secretariate responsible for performing a post-mortem analysis of how the bubble formed and what policy mistakes were made. Kubota says:
The rate of economic growth was around 4 percent, and that was broadly consistent with our view of the economy’s potential growth rate, and prices were extremely stable so there was no fear of an outbreak of inflation. Where we saw risk was on the downside. We were worried that the rate of economic growth would slow. We wanted Japan to have higher growth, and so did foreigners at the time. We did not consider that there was any danger of a bubble economy. There were only two indicators which could have told us; growth in the money supply and the level of fixed investment. If we had studied these indicators, we should have realized what was happening in the financial world, that the cost of money was extremely cheap, that corporations were taking money almost for free and investing in land and fixed investment. We didn’t see it at the time and there were very few opinions along that line …
But even if we had known the answers at the time, there would have been a great deal of difficulty in explaining the need for slowing down the economy. Inflation was low, and there were no external constraints. People prefer high growth to low growth. How could you persuade people that there was a need? The general mood at the time was that people were afraid of slower growth, and the Finance Ministry was no exception. Nobody was thinking about slowing down the rate of growth. Were there any indicators that would have allowed us to find a better course? I think there were two …
It seems that the analysis of the two indicators would have led to proper assessment, and hence to proper policies. One is money supply … [It] had increased by around 8 percent in the previous four years up to 1986 … [It] increased by 10.4 percent in 1987, the year the economy started expanding too rapidly, and continued increasing sharply up to 1990. It grew 11.2 percent in 1988, 9.9 percent in 1989, and 11.7 percent in 1990 … Had economists paid more attention to these now abnormal increases in money supply and tried to search for the cause, they could have found extremely lax lending policies of banks, which not only contributed to a rapid growth of the economy but also weakened financial institutions in the end. While it may be too simplistic to conclude that the money supply dictates economic activities unless you are monetarists, those figures should have drawn more attention.
Another economic indicator that [we] should have studied more carefully was private fixed investment. In 1988 it suddenly increased by 14.8 percent. The following year saw a big increase of 16.6 percent. In 1990, it recorded an 11.4 percent rise … The indicator’s continuous increase at such rapid rates for three consecutive years should have been more critically examined. Though economists were quick to judge that these investments would not lead to overcapacity because the majority of the investments was directed to nonproductive facilities for employees, they were slow to notice that a part of the robust investment was merely a by-product of too much liquidity [in] the firms concerned.
A few pages earlier, the author offered this analysis of the investment surge Kubota describes:
Although Japanese companies were then commonly seen as invincible, given their unimaginably large cash resources, they were revealed to be extremely vulnerable. Corporations’ unchecked extravagance and lack of rigor brought returns on capital to a low point. The return on capital employed in the biggest 245 manufacturing companies in the second half of the 1980s was its lowest since the end of the U.S. occupation following World War II. Consider the deterioration between 1981 and 1991, when their return on total assets fell from 8.9 percent to 5.6 percent. “It’s not that the planning people of major Japanese companies don’t understand about rates of return on capital employed or discounted cash flow,” said a specialist in corporate governance at the Nomura Research Institute, “they knew all about them–but they had cash and so they just had to spend it. They just didn’t care about their returns.”
Kubota’s closing reference to “nonproductive facilities for employees” reminded me of the Versailles-like palace built by that pharmaceutical company in Harbin — a level of “unchecked extravagance and lack of rigor” that is hardly atypical of China’s current investment boom. On a more macro level, it’s worth noting that, like Japan in the 1980s, China is seeing a noticeable drop in returns to capital. According to Bloomberg:
One yuan of GDP now needs about 0.30 yuan of credit, compared with 0.17 yuan in 2002, a shift BlackRock describes as like a car getting less mileage per gallon of gas … In 2009, one yuan of GDP required 0.41 yuan of borrowing, according to data compiled by Bloomberg.
Hartcher’s book also has some fascinating passages related to the role of real estate in Japan’s bubble economy. As he explains:
The bursting of the bubble also exploded one of Japan’s greatest postwar myths. This was the land myth–that the price of land never fell but could only rise … From its 1990 pinnacle, the total market value of land in Japan fell from 2,389 trillion yen to 1,823 trillion yen in 1994, a loss of 24 percent.
You hear precisely the same sentiment today in China — real estate prices have always gone up, can only go up, and won’t go down because the government won’t let them go down. Last week, I saw a presentation by Centaline, one of the largest property agencies in Hong Kong — which you would expect to be a sell-side bull — predicting that China would see a 20-30% drop in primary property prices and up to 10% drop in secondary market prices over the next six months.
Interestingly, Hartcher credits at least part of the speculative run-up in Japanese property prices to the country’s low landholding tax — the absence of which I’ve pointed to as a factor in the Chinese market:
The tax on nonresidential land in Tokyo was found to be the lowest among nine major international commercial capitals when considered in proportion to the rent that land produces. This arrangement provided little inducement to use the land efficiently and dealt out minimal penalties to speculators who held land in anticipation of a price upturn.
Hartcher’s description of Japanese officials’ efforts to control runaway real estate prices proved remarkably similar to the “cooling measures” the Chinese have been implementing since the spring of 2010, and their results:
In pursuing [this] measure–discouraging bank financing of real estate investment–the Okurasho [Ministry of Finance] reached instinctively for a familiar tool, administrative guidance. In the bubble years to 1988, the ministry asked the banks five times to cut back on loans that were to be used for speculative purchases of real estate. Later, the ministry extended this guidance to other financial institutions as well, notably life insurers. This informal and extralegal pressure seemed to work. Market prices of commercial land in Tokyo were down by 4 percent in 1988, and residential land prices fell by 8 percent. But while the fire had been contained in Tokyo, the administrative guidance merely spread the flames to the rest of Japan. In 1988 commercial land prices in Osaka, Kyoto, and Kobe shot up by 21 percent, and residential prices went up 13 percent. Throughout the period of the bubble, at no point did banks ever stop the flow of new lending to the real estate sector. They merely switched locations, moving out of Tokyo, where Okurasho attention was focused, to where it was not–the rest of Japan. The more channels the ministry shut down, the more the banks opened. Banks increasingly used affiliates, leasing companies, and small nonbank institutions …
The shifting of real estate speculation from Beijing and Shanghai, where “cooling measures” were mainly focused, to 2nd and 3rd tier cities is something I’ve been writing and talking about for over a year. The explosion in alternative forms of credit provision (so-called “shadow banking”) as an end-run around lending restrictions is a development that has really taken off this year. Hartcher continues:
The 1988 pause in Tokyo prices sent tremors through the ranks of speculators, whose whole approach was premised on ever-increasing prices. The liabilities of bankrupted real estate companies that year multiplied by 133 percent–from 196 billion yen ($1.96 billion) to 456 billion yen ($4.56 billion)–and virtually all of this amount was attributable to companies described as speculators. Such companies accounted for Japan’s two biggest corporate bankruptcies that year. Did this sober the banks and tame the recklessness of their lending? Not at all. Rather than reduce their exposure to speculators in difficulty, many banks increased it by lending the speculators more money so they could meet the interest payments due to the banks. Tokyo’s weak prices in 1988 turned out to be just a pause. In 1990 they zoomed to new heights, powered by yet more bank lending. The banks had learned nothing. Real estate prices broke new records … The Okurasho’s reflex response to the problem was to impose direct controls and bureaucratic directives.
Hartcher’s description of speculators’ difficulties is virtually identical to my analysis of the recent rash of bankruptcies in Wenzhou. And the response — the Chinese government’s instructions to local banks to expand lending and accept higher levels of non-performing loans, in order to prevent further failures — is strikingly similar.
I may cite further relevant passages, from this and other books on the Japanese bubble, in future blog posts. But for the moment, let me close with this observation from Hartcher:
Viewed through the distorting prism of the economic bubble, the skills of Japan’s bureaucrats seemed to be great indeed and their popular image of superior intellect and ability safe.
When I read this line, it immediately reminded me of a recent comment by Société Générale strategist Albert Edwards about the “blind faith” many observers place in the competence of Chinese officials to guide its economy. Edwards isn’t buying it, and predicts a hard landing. You can read some of his reasoning here. But the main points is this: everyone looks dazzlingly smart before a bubble bursts. Remember when Alan Greenspan could do no wrong? For that matter, remember when Japan was — inevitably — going to take over the world?