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china economics focus what lessons should china learn from japan s lost decade today s tensions between china and the us have many echoes of those between japan and the us in the 1980s including most clearly over the exchange rate the lesson for china is not as some have suggested that china should withstand us pressure on its currency so as to avoid a slide into a japan-style lost decade it is that china should adjust sooner rather than later waiting would cause the needed shift and the associated risks to be larger chinese policymakers are understandably eager to learn what they can from the slide in japan s economic standing since the 1980s so that china can avoid the same fate some have settled on the plaza accord of 1985 as the moment when the decline began in the year that followed the yen gained 36 against the dollar but much of japan s loss of growth momentum since then has been due to other factors such as demographics and as the country became richer the fading of potential for catch-up growth the economy would have slowed anyway regardless of the yen s rise and subsequent asset bubbles moreover as far as the latter are concerned the damage to japan s economy was done not by the exchange rate move itself but by the mismanaged policy response interest rates were kept low for too long fuelling the bubbles and financial regulation was lax there are other examples of economies coping much better with large rapid currency gains including germany after the plaza accord when the deutschmark rose about as much as the yen and japan itself in the early-1970s in other words rapid currency appreciation is not necessarily associated with bubbles or prolonged economic slowdown but the appropriate size of japan s policy response would have been easier to judge if the yen had been allowed to appreciate earlier before pressure became so strong in any case it is important to acknowledge the many differences between today s china and the japan of 25 years ago in the event of a slowdown china still has plenty of room to boost domestic spending whether through credit expansion or preferably by relaxing fiscal policy china s relative poverty means that trend growth should remain strong a final lesson from japan s post-plaza experience is that the impact of the yen s move on japan s surplus was disappointing loose credit policy kept japanese exporters afloat and indeed allowed many to increase capacity similarly a rapid appreciation of the renminbi would not necessarily lead to a sustained fall in china s surplus if it is serious about rebalancing china s government should not only allow the currency to strengthen but commit to structural reforms that will lead to sustainably stronger growth of domestic consumer demand mark williams tel +44 0 20 7811 3903 north america 2 bloor street west suite 1740 toronto on m4w 3e2 canada tel +1 416 413 0428 managing director chief international economist senior china economist china economist europe 150 buckingham palace road london sw1w 9tr united kingdom tel +44 020 7823 5000 asia #26-03 hitachi tower 16 collyer quay singapore 049318 tel +65 6595 5190 roger bootle roger.bootle@capitaleconomics.com julian jessop julian.jessop@capitaleconomics.com mark williams mark.williams@capitaleconomics.com qinwei wang qinwei.wang@capitaleconomics.com china economics focus 1 8th nov 2010

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what lessons should china learn from japan s lost decade the current tensions between china and the us share many similarities with those between japan and the us a quarter of a century ago first there are parallels in economic circumstances china is the world s second largest economy today as japan was then with each accounting for around a tenth of global output china s current account surplus is a similar size relative to world gdp and the backdrop of us economic weakness and a gaping current account deficit was also in place in 1985 see chart 1 chart 1 gdp current account balances all as a of world gdp 12 10 8 6 4 2 0 japan china 1985 2010 japan china 1985 2010 us us 1985 2010 gdp lhs curr account surplus rhs curr account deficit rhs 1.2 1.0 0.8 0.6 0.4 0.2 0.0 growth remained fairly strong to the end of the decade supported in part by bubbles in equity and real estate markets but when these bubbles burst the economy slumped japan never returned to its pre-plaza rate of growth see chart 3 chart 2 yen exchange rates 180 150 120 90 60 louvre accord 30 0 70 75 80 85 90 95 00 05 10 plaza accord 400 240 320 yen stronger 160 yen trade-weighted exchange rate rhs yen inverted lhs 0 80 source ­ thomson datastream chart 3 japan gdp growth y/y 10 8 6 4 2 0 -2 -4 -6 1980 1985 1990 1995 2000 2005 2010 plaza accord bubbles burst averages 1981-1990 4.7 1991-2000 1.2 2001-2009 0.5 10 8 6 4 2 0 -2 -4 -6 sources ­ imf capital economics in the 1980s as now righting these external imbalances became a global policy priority with exchange rates the focus of attention then us calls for the yen and deutschmark to appreciate against the dollar were answered with the plaza accord in september 1985 the yen strengthened by 11 against the dollar in the next 10 days moving from 240 to 214 and gained 36 over the course of a year many in china now suggest that the subsequent decline in japan s economic standing offers a clear lesson in the dangers of giving in to foreign demands to rebalance through exchange rate shifts the yen steadied against the dollar following the louvre accord of february 1987 but its earlier gains were sustained see chart 2 economic source ­ thomson datastream the aftermath of the plaza accord it seems plausible that the weakness of the 1990s was related at least in part to the yen s rapid appreciation after 1985 the most obvious link is through the impact of the yen s rise on exports these dipped in both volume and yen terms as the currency rose export volumes were back at the 1985 level after three years however exporters earnings in yen terms did not climb substantially above the pre-plaza level until the late-1990s see chart 4 china economics focus 2

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chart 4 japan exports seas adj sep 1985 100 180 volume of exports 160 140 120 100 80 60 1980 1985 1990 1995 2000 value of exports in yen level at time of plaza accord 160 140 120 100 80 60 180 remained subdued and japan was under pressure after the louvre accord to keep interest rates low in order to stop the yen s rise against the dollar which the us thought had overshot as a result the bank of japan held off from tightening monetary policy until may 1989 the bubbles in real estate and equities continued to build we discussed how these events led japan into a lost decade in a global economics focus a fresh look at the lessons from japan 22nd december 2009 but what are the lessons for china why should appreciation trigger bubbles a first observation is that the policymaking errors that set the stage for japan s bubbles and their subsequent collapse lay in the ineffective response to the currency move rather than the appreciation itself these errors were not inevitable the essential problem faced by japan s policymakers in the 1980s and china s today was how to boost domestic demand to offset a decline in net exports a loosening of monetary policy is one element of the possible response others are more expansive fiscal policy and structural reform to increase domestic demand there is no reason to expect that any particular policy combination should necessarily lead to the creation of asset bubbles however the risk is increased if the emphasis is placed on a monetary response in japan s case while interest rates were cut and kept low for a sustained period fiscal policy was not brought into play until well after the bubbles collapsed instead as low interest rates supported a strong recovery fiscal policy was tightened see chart 6 the opposite approach of using higher interest rates to control credit growth while loosening fiscal policy would probably have had less damaging effects even so japanese asset prices would not have reached the heights they did were it not for weaknesses of financial market oversight and the failure of market participants to acknowledge that source ­ thomson datastream it seems clear that the exchange rate move did undermine export sector earnings but the story does not end there the yen s rise should also have spurred domestic spending by boosting yen purchasing power and by lowering inflationary pressure within japan yen appreciation should have given space for the authorities to pursue more expansionary policies indeed this is what happened in the months after the plaza accord the bank of japan cut the policy rate from 5.0 to 2.5 see chart 5 chart 5 japan exchange rate official interest rate 300 250 200 150 100 50 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 yen stronger yen/dollar lhs bank of japan discount rate rhs 10 8 6 4 2 0 plaza accord source ­ thomson datastream this had the desired effect of rapidly stabilising and then accelerating growth in 1987 gdp growth rebounded to 4 in 1988 japan grew by 7 the most in 15 years low interest rates encouraged a surge in lending some fed investment in industry sowing the seeds of overcapacity a few years down the line but the impact showed up most immediately in soaring asset prices meanwhile consumer price inflation china economics focus 3

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japanese trend gdp growth was slowing indeed some commentators believe that such factors on their own are sufficient to explain the bubbles of the late-1980s and that monetary policy was not at all to blame see the recent speech by bank of england mpc member adam posen ­ www.bankofengland.co.uk/publications/speeches 2010/speech456.pdf chart 6 government budget balance gdp 4 2 0 -2 -4 -6 -8 -10 -12 1980 1985 1990 1995 2000 2005 2010 china japan deficit surplus 4 2 0 -2 -4 -6 -8 -10 -12 chart 7 equities in japan from 1982 and china from 2007 600 500 400 300 200 100 0 1982 2007 1984 2009 1986 2011 1988 2013 1990 2015 1992 2017 plaza accord china shanghai composite from jan 2007=100 japan topix from jan 1982=100 600 500 400 300 200 100 0 source ­ thomson datastream sources ­ imf ceic finally while japanese policymakers sat back as equity and land prices rose to levels that looked ridiculous even at the time chinese officials are already trying to prevent the relatively mild property price increases of the last year or so from getting out of hand there is of course no need for similar action to calm over-exuberant animal spirits in the equity markets this is not to say that china would definitely not run into trouble bubbles typically start to grow following some form of economic shock and an abrupt exchange rate appreciation coupled with policy loosening could be the trigger as it was in japan chinese regulators may avoid some of japan s mistakes but make a few of their own even if a bubble were avoided china s banking system is not an efficient allocator of capital the government is already worried that the credit expansion of the last couple of years will leave banks saddled with large amounts of nonperforming loans one lesson from japan is that high debt levels can undermine domestic demand growth for years but there is no particular reason to believe as some seem to today that japan-style bubbles would necessarily build in china nor does that even seem particularly likely for example once equity prices took off crossholdings between banks and firms magnified the gains and the subsequent collapse financial deregulation earlier in the decade and favourable tax treatment were additional factors that channelled the flow of credit into japanese property and equities china can learn from these failings and avoid them in some important ways china already looks very different from the japan of 1985 equity investors are still smarting from wounds inflicted when share prices collapsed in 2007 today s trailing p/e ratio in shanghai 20 is well below the average of the last ten years 33 over the last year chinese shares have been among the worst performers anywhere in the world see chart 7 this contrasts with the optimism that helped japanese share prices rise by half in the three years before the plaza accord the p/e ratio in tokyo had already reached 32 by then compared with an average over the previous decade of 22 the ratio would peak at 61 in december 1989 china economics focus 4

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how similar are china and japan really other differences indicate that china would be able to mobilise a far more effective policy response to any downturn that did occur the biggest difference between china now and japan then is that japan was already rich by 1985 japanese income levels in ppp terms were nearly three-quarters of those in the us chinese incomes today are still only a sixth of the us level the per capita capital stock in china is roughly 5 of that in the us because china has so much room to catch up its policy options in the event that an asset bubble collapsed or growth slowed dramatically would be much broader for example there is ample room for the government to increase spending on healthcare or education or to strengthen public infrastructure these interventions would bring long-run benefits to chinese growth by contrast japan s government brought in a series of fiscal stimulus measures in the 1990s but they were poorlytargeted bridges to nowhere why should china slow the final reason to doubt that japan s experience after 1985 offers many clues to what might happen in china is that japan s growth was set to decline anyway whatever happened to the yen in part this was due to unfavourable demographics that lowered the sustainable growth rate in the 1990s the bigger picture is that having made the transition to being an advanced economy japan s years of rapid catch-up growth were over rather than the 1980s marking a turning point japan s growth peaked at the end of the 1960s a decade and a half before the plaza accord the bubble years in the late-1980s only masked the continued decline by contrast china s growth may only have peaked recently see chart 8 the level of per capita income relative to the world s most advanced economies is in fact one of the best predictors of future growth this is clear from chart 9 which shows the relationship between relative income levels and subsequent growth for 24 countries over two periods 19501980 and 1980-2008 chart 8 gdp growth in japan china y/y 16 12 8 4 0 -4 -8 1955 1980 1965 1990 1975 2000 1985 2010 1995 2020 2005 2030 china from 1980 japan from 1955 plaza accord 1985 16 12 8 4 0 -4 -8 sources ­ imf ceic chart 9 relative level y/y growth of income ave ann per cap gdp growth 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 0 china in 1980 japan in 1950 china today 1950-1980 1980-2008 japan in 1980 20 40 60 80 100 per capita income us at start of period 120 source ­ maddison note data cover 16 countries in western europe and six in asia plus canada and the us the growth japan has experienced since 1980 is exactly what one might have expected given its income level at the time by contrast china today with an income level one sixth of that in the us is roughly where japan was in 1950 with decades of strong growth ahead of it what can we learn from other revaluations china s advantages don t stop with its relative poverty its policymakers also have the opportunity to learn from where japan went wrong and where other countries got it right in similar circumstances indeed there are other perhaps more relevant examples of rapid currency adjustment in japan that chinese policymakers can look to as well china economics focus 5

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the mid-1980s was not the first time japan faced foreign calls to revalue the yen the first bout of us pressure on japan came towards the end of the bretton woods period in the late-1960s at that time japan was already wealthier relative to the us than china is today making it not a perfect model incomes were two thirds of those in the us but japan was still a decade away from being one of the world s most developed economies japan resisted us pressure and maintained the yen s peg by contrast germany allowed the deutschmark to strengthen starting in 1969 but japan gave in following president nixon s august 1971 introduction of a 10 surcharge on imports which was designed to put pressure on surplus countries to allow their currencies to appreciate this was the nixon shock japan allowed the yen to strengthen by 26 over the next two years see chart 10 chart 10 yen/deutschmark vs dollar inverted 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 1964 1966 1968 1970 1972 nixon shock 1974 1976 1978 1980 dm lhs yen rhs stronger against dollar 0 50 100 150 200 250 300 350 400 path to that of the yen after the plaza accord see chart 11 chart 11 yen/deutschmark vs dollar inverted 0 50 100 150 200 250 300 350 1984 1985 1986 1987 1988 1989 1990 1991 1992 plaza accord yen lhs dm rhs stronger against dollar 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 source ­ thomson datastream germany did not experience a japan-style asset bubble because the policy response was more measured and germany s financial sector did not suffer from the same weak regulation both fiscal and monetary policy were loosened the bundesbank initially cut interest rates by a similar margin to the bank of japan but it began to raise them again far sooner by the time of the first bank of japan rate increase the bundesbank had already raised its policy rate four times see chart 12 chart 12 japan germany policy rates 8 7 6 germany japan 8 7 6 5 4 3 plaza accord 2 1 0 1984 1985 1986 1987 1988 1989 1990 1991 1992 source ­ thomson datastream 5 4 3 2 1 0 the bank of japan duly slashed interest rates as it would in 1985 and ­ unlike in 1985 ­ fiscal policy was loosened policy then had to be tightened abruptly as inflation picked up growth was slower over the years that followed partly because the subsequent oil price shock forced a sharper tightening than would otherwise have been needed however the key for china is that japan did not suffer a lost decade alternatively china could look to germany whose currency moved on a virtually identical source ­ thomson datastream the point here is not to suggest that china today resembles the germany of 1985 more than the japan of the same time it is to underline that a sharp currency revaluation does not have to lead to a lost decade-style slump in growth indeed given the marked differences in china s situation that seems most unlikely china economics focus 6

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conclusion in fact the conclusions that we can draw are quite different policymakers are right to worry about the negative impact of big exchange rate shifts but the lesson from japan in the 1980s as well as other similar episodes is that judging the policy response is crucial a balanced approach including fiscal as well as monetary policy may lower the risk of bubbles forming as is more widely understood today policymakers should watch asset prices as well as consumer prices for signs of overheating however the appropriate policy measures will inevitably be hard to judge for this reason it makes sense to move sooner rather than later waiting will mean that the required currency movement and offsetting policy intervention will be larger that said china is in a far better position to introduce effective policy stimulus in the event of bubbles bursting or a sharp growth slowdown its fiscal position is strong and the continued need to build infrastructure expand cities to accommodate an urbanising population raise spending on healthcare and education and so on means there is no shortage of worthwhile projects on which to focus a policy response most important given its relative poverty china should be able to grow rapidly for decades to come japan s bubbles were the result in large part of its post-plaza policy response as well as regulatory failings but a slowdown in growth in the 1990s would have happened anyway as the country became richer and its population grew old there are lessons too for china s critics the yen s rise after the plaza accord was more dramatic than even the us had hoped for ­ to the extent that the us pushed just 17 months later at the louvre accord for the yen s gains to be capped but the impact on japan s surplus was smaller than many had expected the surplus dropped slowly in the second half of the 1980s but in dollar terms was still not far below its 1985 level by the end of the decade the surplus subsequently rebounded see chart 13 chart 13 japan current account surplus 6 $bn rhs 5 4 3 2 1 0 1980 1985 1990 1995 2000 2005 2010 gdp lhs 200 150 100 50 0 -50 250 source ­ imf the explanation again lies partly in the policy response cheap credit allowed japanese exporters to stay afloat and indeed to boost capacity as chart 4 showed the volume of japan s exports continued its steady rise in china s case those pushing for a big exchange rate move assume that the shift will boost domestic spending either directly or indirectly by pushing policymakers into enacting needed structural reforms however this is not certain the shift that the rest of the world hopes to see in china is in faster growth of domestic demand relative to supply a significant loosening of credit policy could also support continued expansion in industrial capacity in other words currency appreciation is only one part of the solution needed for rebalancing if it is serious about bringing down the external surplus china s government should not only allow the currency to strengthen but commit to structural reforms that will lead to sustainably stronger growth of domestic consumer demand china economics focus 7

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