Aranca Views - Is China Where Japan Was in The 1980s

s
China The Japan of the 80s?

October 31, 2014
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P a g e | 1
Is China where Japan was in the 1980s? The jury is still out!
A slowdown in the worlds second largest economy and the probability of a potential hard-landing has been well documented now. We
believe Chinas current investment appeal (read equity market valuations) too reflects the medium-term impact of a softening economic
growth. What, perhaps, is not a consensus currently is whether China is treading towards a lost decade, much like Japan in the 1990s.
What prompts us to think in this direction are a series of factors behind Chinas recent strong growth bearing visible similarity to those
behind Japans economic performance in the 1980s. That being said, there are also factors where China differs from Japan and could
possibly avoid a near similar situation. The jury, it appears, is still out on this.
China GDP growth rate at constant prices (y/y) Japan GDP growth rate at constant prices (y/y)

Source: Japan Statistics Bureau, National Bureau of Statistics of China
The most glaring of the similarities is the expansion in domestic credit and its role in driving economic growth in both countries. Japans
domestic credit as a percentage of GDP expanded from around 1.8x at the start of 1980s and climbed up to as high as 2.6x by the time
economic growth started to taper off in the early 90s. China too has seen significant increase in the amount of credit made available in
the system. Total domestic credit to GDP in China has increased to nearly 2.0x from 1.2x at the start of the last decade. In fact, a
similar expansion occurred much more recently 2009-2013, as part of the overall global economic recovery after the 2008 crisis.
Significant asset price inflation accompanied credit growth
The impact of such credit expansion has also been fairly similar in the two economies, i.e. a resultant asset price inflation, most notably
real estate. The Economists house-price indices for Japan and China show remarkable trends from 100 in 1980 to 205 at the end of
1990 for Japan, and from 100 to 207 for China over 2000-2014.
Domestic credit/GDP Japan Domestic credit/GDP China

8.3%
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October 31, 2014
P a g e | 2
Economist house price index comparison Urban Commercial land prices, y/y change Japan

The chart on the right above shows the dramatic collapse in commercial real estate prices in Japan after nearly a decade of high credit
and strong economic growth. The sharp fall in the real estate prices in Japan also had a significant impact on the countrys financial
sector. A large portion of the credit in the market was collateralized against commercial and residential real estate and a drop in the
sector spiraled into the banking space. In China too, corporate debt, a big chunk of which is collateralized against real estate properties
(mostly commercial), has soared in the recent past. The current level points to corporate debt nearly 130% of the countrys GDP.
Will the real-estate sector be Chinas Achilles heel too?
Should the real estate sector in China suffer a major downturn, its impact on the overall economy could potentially be material. Given
the trends seen in the recent past, it would be unwise to not be wary of such a possibility. In a recent note published by Aranca, China
Property Market: Prepare for the End Game? September, 2014, analyst Nikhil Salvi points to a visible correction in the market and
possible steps being considered by the government to stem it. Sale of commercial real-estate was down by an average 9% in 1H2014
v/s a growth of 35% in 2013. Prices of residential properties fell on a m/m basis in 64 of the top 70 cities in July 2014 v/s just four in
2013 alone.
Investment in RE development, y/y change - China Fund sources for RE developers, y/y change China

Source: National Bureau of Statistics of China
The impact from a softening real-estate market in China could not only impact the corporate sector and its economic growth, it is also
likely to inflate a certain degree of social unrest, given the existing affordability issues and lower disposable income levels in China
compared to Japan in the 1980s.
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October 31, 2014
P a g e | 3
China too suffering from an ageing population and a softening exports sector
For economies such as Japan and China and several other Asian nations, working population growth is a reasonable measure of how
steady and sustainable economic growth can be. Chinas current working age population (15-64) is witnessing a steady decline in
growth, similar to what the early 90s in Japan. We believe Chinas one-child per family policy, which has been in place for a number of
years now, has been the reason behind the plateauing working population.
Working population growth Japan Working population growth China

Another common ground between Japan and China has been their reliance on exports to drive the economy. While Japans export
industry softened largely as a result of the Plaza Accord which led to a stronger Yen, the resulting stimulus and expansionary policies
eventually caused the bubble to bust and further constrained the export industry. China on the other hand, appears to be consciously
controlling its exports and focus more on increasing domestic consumption. Given the difference in the demographics between the two
nations and given the recent drop in exports growth, domestic consumption patterns need to change meaningfully for them to support
overall economic growth.
Growth in exports, y/y change Japan Growth in exports, y/y change China

Further, we believe that Chinas competitive advantage in its exports industry has a long-term declining trend given the rising labor
costs, production costs and increased focus on climate control and environmental issues globally. While Japan suffered from a
structural appreciation in Yen especially after the 1985 Plaza Accord, Yuans appreciation has been much more gradual. That being
said, rising labor costs in China have acted as a double whammy making exports a lot more uncompetitive now than a few years ago.
0.7%
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October 31, 2014
P a g e | 4
China labor cost and currency movement Significant appreciation in Yen post Plaza Accord

Where there are similarities, there are differences too
While there are some striking similarities in the growth recipe for China versus what Japan experienced in the 1980s, we list down
some differences too. While some may apply the much clichd too big to fail argument in Chinas case as well, we do note some
structural differences in the two economies as well.
China remains relatively below-par when it comes to urbanization levels. A good percentage of the population still lives in semi-urban
and rural areas and presents an opportunity to push for higher domestic consumption through increased economic standards. Also,
Chinas current urbanization levels are similar to what Japan had in the early 1970s. A rapid increase in Japans urban population
played a crucial role in driving the countrys economic growth in the 1970s and mid-1980s.
Urbanization percentage Japan v China GDP per capita Japan v China (USD)

Source: World Bank
The other major difference and partially a result of the lower urban population, is Chinas significantly lower per capita GDP compared
to where Japan was in the 1980s, nearly 1/6th currently. Both these factors for China were present in case of Japan at a time when the
latter was at the cusp of a continued high growth phase.
Another important point to note is Chinas current population employed in the agriculture sector. With as much as half the population
living in semi-urban and rural areas, the agriculture sector currently supports nearly 30% of the countrys population. The percentage
has steadily declined over the past three decades, but still remains sizeable. Japan on the other hand had nearly 90% of its population
employed by non-agriculture sectors in the 1980s. We believe that a higher agriculture employment presents a few opportunities 1)
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Labor cost index USDCNY
20
30
40
50
60
70
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100
110
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USDJPY
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Japan China
35,451
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1000
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6000
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Japan China
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October 31, 2014
P a g e | 5
China agriculture employment trend

Despite a steady decline, Chinas current agriculture
employment still remains high at around 30%
We believe this offers opportunities for China:
1) A shift to urban and non-agriculture employment could
increasing domestic consumption and mitigate the
impact of softening exports
2) a shift from agriculture to non-agriculture employment
would also offset the ageing working population
Source: World Bank
it gives China the opportunity to increase the economic standards of its average populace, thereby increasing domestic consumption
and mitigating the impact of softening exports, and 2) a shift from agriculture to non-agriculture employment could take care of the
ageing working population in the urban areas, an advantage which Japan did not have in the 1990s when its economy began tapering
off.
We also believe that, given the above factors, China does have room to grow out of the middle-income group into a well-diversified
higher earning, spending and consuming upper-middle class. We note that, although there are striking similarities between the current
Chinese growth scenario and the Japan of the 1980s, there are opportunities that can help China avoid a prolonged limp in growth.
That being said, a lot of these structural opportunities need to be exploited with prudent government policies and controlled and
measured investments. Although a lost decade for China may still remain far-fetched, it remains to be seen how the rest of the decade
unfolds and whether the current hawkish investor stance changes.
Policy measures that can avoid a Japan-like scenario and capitalize on the favorable differences:
Despite the setup in China being a lot similar to Japan prior to its Lost Decade, what differs in Chinas case is the governments
intentions, although partial, towards taking a tough stand and implement non-populist measures. We believe that, being a non-
democratic government is a key differentiator that could make China well equipped to provide a soft-landing, should the need arise. To
this effect, the government has already implemented some preemptive measures like liberalizing the economic sectors in a timely
manner, reducing states dominance and reforming the financial system.
The extent of growth in unproductive capital formation in China is much greater than what Japan had at a similar phase of development.
The overinvestment in China has largely been driven by the lower rate of borrowing that the state-owned entities have enjoyed, coupled
with the benefits of monopolistic pricing and government subsidies. Withdrawal of these state-sponsored economic moats would make
these entities financially unviable, leading to pile up of nonperforming loans and bond defaults.
However, we believe the following factors are favorably stacked up in China that would help it avoid a fate similar to that of
Japans:
Growing international pressure to reduce its massive trade surplus would mean appreciating its artificially undervalued
currency. With the export story hinging on the currency competitiveness, the country has been gradually scaling back on its
protectionist measures, thereby placing a cap on the over investments in sectors with over capacity
Unlike Japan, where developed domestic markets were already saturated to absorb the output that lost its export sheen, China
has a relatively developing domestic market. This would likely absorb the surplus output from the already installed capacities
thereby providing a cushion and reducing the prevalence of bad loans.
Chinese authorities also seem to be actively involved in instilling confidence by taking proactive and non-populist measures,
something that lacked in Japans case. Measures like Chinese Central Bank injecting 500 billion yuan into the country's
25
30
35
40
45
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55
60
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October 31, 2014
P a g e | 6
undercapitalized top banks (providing buffer against the increasing bad loans) and expanding the municipal-bond market
allowing localities to refinance with direct bond sales will boost sentiment in the financial system. Property markets have also
seen measures like improving mortgage loan criteria and increasing tax rates to reduce speculative purchases to address
asset bubble concerns. Meanwhile, Pension scheme reforms of uniting the urban and rural systems, would see increased
public funds lending support to the local markets.
Curtailing Shadow Banking: Shadow banking has been one of the primary concerns, which is estimated to have artificially kept the
interest rates lower. Smaller banks in China, faced with stringent competition, have been more aggressive to adopt shadow banking,
fueling growth for interbank activities. With a view to instill confidence in the financial system and stem the growth of shadow banking,
policymakers recently tightened market liquidity to address alarming levels of interbank funding transactions. Beijing has also been
tightening its policy on wealth management products, cross-border arbitrage flows and the bond market aimed at curbing the money
flow into the riskier shadow banking activities. Initiatives like these are an indication of the governments intent to tackle the growing
public debt menace and avoid a fate as that of Japans. We believe such measures would see China continue on a path of growth,
which although might be lower than the standards it achieved in the past three decades, but would be safer than the path Japan found
itself on.
Shadow banking China

Some of the policy actions taken by the government to
curb the growth in shadow banking in China include:
1. Regulations on wealth management products by issuing
accounting rules for banks for such products
2. Less aggressive stance on injecting liquidity in the
system in a scenario of sudden spike in interest rates
3. Stronger auditing of local government and municipality
debt
4. Setting up a financial regulation coordination entity
under the purview of the PBoC and other financial
institutions
Source: National Bureau of Statistics of China

Research Note by: Avinash Ganesh Singh with contribution from Lekha Badlani, Nitisha Pagaria and Tushar Patil

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Regulated lending Unregulated lending (CNY bn)
s

October 31, 2014
P a g e | 7

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securities, commodities or currencies suggested. Such statements, estimates, and projections are based on information that we
consider reliable and may reflect various assumptions made concerning anticipated economic developments, which have not been
independently verified and may or may not prove correct. No representation or warranty is made as to the accuracy of such statements,
estimates, and projections or as to its fitness for the purpose intended and it should not be relied upon as such. Opinions expressed are
our current opinions as of the date appearing on this material only and may change without notice.
2014, Aranca. All rights reserved.

Aranca Views - Is China Where Japan Was in The 1980s

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China The Japan of the 80s?

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