China: The graveyard for investment white elephants

The new administration in Beijing realises it has a problem. Policies directed towards delivering fast and stable economic growth have produced a profoundly unbalanced economy. Japan, which followed a similar type of development model during its high-growth period, found itself in a comparable position in the late 1990s. As the economy growth slows and the credit system creaks, is China lurching towards its own "lost decade"?

It is commonplace to compare China's current economic development with that of Japan about 40 years ago. China's gross domestic product per capita, at just below 20 per cent of the US level, is at roughly the same point Japan reached in the early 1970s. However, as Beijing university professor Michael Pettis points out in his new book, The Great Rebalancing, the more telling comparison is with Japan in 1990, when the bubble economy burst.

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Both China and Japan have adopted the so-called "Asian growth model". This involves generating breakneck economic growth with very high levels of investment and export expansion. Manufacturers are subsidised with cheap capital, while exports are boosted by an artificially depressed exchange rate. National savings are encouraged, at the expense of domestic consumption. Low interest rates reduce the return on household savings, while a cheap currency makes imports more expensive.

This set of mercantilist policies delivers economic miracles during the boom years, but it tends to culminate in excess investment, lacklustre domestic demand, credit and real estate bubbles, and the widespread misallocation of capital. The macroeconomic imbalances produced by China are on an epic scale, far exceeding Japan's imbalances during its glory years. Chinese excess savings - as measured by the current account surplus - peaked a few years back at 10 per cent of GDP. Japan's surplus never exceeded 4 per cent of GDP. Investment has climbed to near 50 per cent of China's GDP, nearly double Japan's peak investment rate, while Chinese consumption has shrunk to little more than one-third of economic output.

There is much talk of China "rebalancing". But as Japan discovered, it can be difficult to dismount the investment treadmill. Eventually, Japanese consumption did rise as a share of GDP in the 1990s. This was achieved, however, through a collapse in investment and economic growth rather than a surge in consumer spending.

China's credit system looks as fragile today as Japan's in the late 1980s. Both economies ended up with non-financial debt exceeding 200 per cent of GDP. Both financial systems have seen credit explode outside their formal banking systems. In Japan's case, finance companies and jusen (non-bank) banks lent to the property sector. In China, the shadow banking system performs a similar role.

Bureaucrats dominated Japan's credit system in the 1980s. Beijing officials have even greater sway over their banks. In both cases, they have fostered the belief that key financial players are too big to fail. In both countries, loans have been made according to political connections or to further government industrial policy, without due consideration of the cash flows necessary to repay the debt. Japan socialised financial risk. China has followed its lead.

In both Japan and China, non-performing loans have been swept under the carpet, or "evergreened". As long as economic growth remains strong, potentially bad loans can be ignored. But problems emerge once growth slows. After Japan's bubble burst, Tokyo's financial safety net turned out to be full of holes. Numerous small banks failed, while the largest banks were either nationalised or merged.

A reluctance to embrace corporate bankruptcy prevents capital from being redirected towards more efficient uses. In the long run, this reduces productivity and retards economic growth. In Japan, corporate "zombies" weighed down with debt emerged in the 1990s. Beijing mandarins likewise go to great lengths to avoid bankruptcy. Failing Chinese shipbuilders, steel companies and solar panel manufacturers are constantly being bailed out with fresh loans.

The Asian growth model is designed to maximise production rather than returns on capital. Its policies foster the misallocation of capital. Corporate Japan has earned miserable profit margins for as long as anyone cares to remember. In recent years, Chinese corporate returns have been drifting towards Japanese levels. After its recent investment splurge, China is fast becoming a graveyard for investment white elephants.

Prof Pettis argues that it will be difficult to rebalance China's economy. Nonetheless, he expects economic growth over the next decade to average around 5 per cent or less. While this is below consensus expectations, he is not anticipating an economic catastrophe.

My own view is rather more pessimistic. The fate of China's banking system and economy has become inextricably linked with its overbuilt and overpriced real estate market. After Japan found itself in a similar position in 1990, it experienced two decades of economic stagnation. China will be lucky to escape such a fate.

Edward Chancellor is a member of the asset allocation team at GMO, the investment manager.