Transcript

Making sense of China’s big economic reboot

By Reuters

This transcript was created using speech recognition software, it may contain errors. Please review the episode audio before quoting from this transcript.
Peter Thal Larsen
What is going on in the Chinese economy? It’s a question that has preoccupied economists, investors, executives and policymakers for decades. But it’s worth asking again today. That’s because in recent weeks, Chinese authorities have unveiled a series of measures which seemed designed to reverse the malaise in the world’s second largest economy. First, the People’s Bank of China, the country’s central bank, cut interest rates, unveiled measures to boost the ailing housing market, and created schemes to help institutional investors and companies buy shares. Then the authorities announced they would borrow to help poorer households. They would also allow indebted local governments to swap bonds. And they’re planning to inject more capital into the country’s largest banks. All of this has excited investors. The Chinese stock market is up more than 20% since the middle of September. And there may be more to come. Reuters reported last week that China was considering issuing 10 trillion yuan, that’s $1.4 trillion, in extra debt over the next few years.
Peter Thal Larsen
But it’s far from clear that this will be enough. China is grappling with deflation, debt and slowing growth, which has cast doubt on President Xi Jinping’s ambitious plans to transform the country. China is also facing new trade barriers in Europe and elsewhere, and it will soon have to deal with a new U.S. president, possibly Donald Trump. So this week on The Big View, we’re going to look at what is next for the Chinese economy. It’s what we do at Reuters Breakingviews. We tap our best sources around the world to bring you fresh insights into the biggest stories in global business and finance. I’m your host, Peter Thal Larsen.
Peter Thal Larsen
And I can hardly think of a better person to help unpick this topic than Arthur Kroeber. Arthur has been writing about and studying the Chinese economy for decades, first as a journalist, then as a founder of Dragonomics, and since 2011 as head of research at Gavekal, the independent analysis firm. He’s also an adjunct professor of economics at the Stern School of Business at NYU, a member of the Council on Foreign Relations, and a senior fellow at the Brookings Tsinghua Center in Beijing. He’s also the author of an indispensable book, “China’s Economy: What Everyone Needs to Know”. Arthur Kroeber, welcome to The Big View podcast.
Arthur Kroeber
Very glad to be here.
Peter Thal Larsen
So Arthur, we’ve seen all these, this flurry of announcements from the Chinese authorities, from the People’s Bank of China, from some of the other authorities. Maybe just we could just start by getting your broad take on these policy moves. To what extent have you been surprised by them, and what do you think prompted them?
Arthur Kroeber
Well, so, yeah, I was a little bit surprised because for many months China had been experiencing, you know, pretty poor economic conditions, sluggish growth, very poor consumer demand, weak employment, etc., etc. And the government seemed not to care that much. They were not really doing anything in response to this. And one reason for this is that their overall strategic objective is to shift the structure of the economy, to essentially suck money out of the real estate sector and put the capital into technology intensive manufacturing, on the theory that this is what’s going to drive future productivity growth and prosperity and national strength. And the reality is that strategy seems to be working. I mean, if you look at the data on where bank loans are going, if you look at all measures of capital raising, more and more money is going into the high-tech sectors, the property sector’s getting less and less, and the high-tech sectors are doing pretty well. You know, we all know about the success of electric vehicles and the green energy companies. But even if you drill down to a wider array of sectors that are government priorities, semiconductors, industrial robots and so forth, they’re doing well, they’re investing more, they’re filing a lot of patents and so forth. So the government seem to be saying, look, we know this is painful, but our strategy is working, so what’s the problem, right?
Arthur Kroeber
And then in September, suddenly they said, oh, actually it seems like there is a problem and we’ve got to deal with it. And I think a lot of people are speculating about why it was that they made this sudden shift. And I think there are a couple of reasons. One is that by the end of the summer in August, some of the economic data was really quite poor, and particularly if you look at the indicators in employment, they’d gotten very, very weak, as in early Covid pandemic area sort of weakness. And so there seemed to be a steady deterioration. The export numbers were strong, but there was a little bit softness. And obviously I think everyone’s looking ahead to a possible Trump presidency, a lot of tariffs, what that could do to the exports. But I think the most common explanation that I hear is that they got worried that the bad state of local government finances was, actually -- had the risk of leading to certain kinds of social stability problems, that local governments in many areas are unable to pay their employees, there are a lot of back wages, they can’t pay their suppliers. And there seem to be some rumblings that this was beginning to create, you know, a real risk of discontent. And as far as I can tell, that seems to have been the major spur to the sudden pivot. Now, the other thing I would say, though, is that if you look at the measures that they’ve rolled out over the last six weeks, they’re very broad, they’re very coordinated. They kind of sit together well. So it’s clear that the technocrats had been working for quite a while on, you know, if we get the green light to support the economy, what do we do? So they were able to move, I think, fairly quickly to do a range of things. So I think what was missing was a signal from the very top that it was important to support the economy, that finally came, you know, for whatever reason. And now they seem to be in sort of full on let’s support the economy mode.
Peter Thal Larsen
So what -- if this is a coordinated set of measures, and obviously we’re still waiting for various bits and pieces to come out, but what is, how should we think about these how these things fit together, and what should the results be, do you think?
Arthur Kroeber
Right. So I think first, probably we should talk about what they’re not trying to do, because I think a lot of the market commentary has sort of assumed an intent that isn’t there, right. And I call this a stabilization package, not a stimulus package. The purpose of this is not to engineer a new boom of growth. So this is very different than the stimulus packages that you saw, notably in 2008, but also in a couple of subsequent periods such as 2015, where they were really trying to gin up growth. Now, essentially what they’re trying to do is put a floor under growth and to shift the focus of property policy from being very restrictive, to shrink the property sector, to say, okay, we’ve done the shrinkage, now it’s time to stabilize and restore some confidence. So it’s about stabilization. It’s not about reflation in a broader sense. And they haven’t abandoned their core strategy, which is, growth is driven by investments in high-tech manufacturing. So they were never going to do any kind of large scale consumer stimulus because that’s not really what they do, and that’s not part of the purpose here, nor were they going to do the kind of big infrastructure stimulus that has driven previous, previous reflation efforts.
Arthur Kroeber
So what they are trying to do though, is, you know, put a floor under things and and restore some order in the property market. So the -- and, and also to take some of the fiscal pressure off of local governments. Those are kind of the key features. And so what they’ve done is, number one, the central bank cut a bunch of interest rates. Number two, in order to make the transmission of monetary policy more effective, they’ve proposed a major recapitalization of the biggest banks in the country. And some people have asked, well, the big banks are fine, they’ve plenty of capital, it’s the small banks that need capital. Why are you giving more capital to the big banks? And the reason for that is that the big banks are systemically important. They’re the ones that really drive the transmission of monetary policy. So if you want them to do their job, they need more capital to take on extra risk, particularly in the property sector, which is where the government wants them to take on more risk.
Arthur Kroeber
So those two things, I think fit together pretty well. And then the other major thing that they’re doing, they’ve had a whole host of different measures in the property market. They’ve had a major deregulation of mortgage, mortgage policies. So it’s easy to refinance. There’s no discrimination between whether it’s your first property, your second property. They’ve authorized local governments to remove most of the administrative restrictions on property purchases, etc., etc. So it’s a whole suite of things to try and get more juice in the, in the property sector, along with financing to basically enable these white lists of approved projects to get completed. So there will be some more finance going to developers to finish up projects there that are part way done. So it’s a fairly comprehensive and well integrated property policy.
Arthur Kroeber
And then the final thing that they’re doing is refinancing some of the local government debt. We don’t know the amount yet, that will be announced probably in a week or so, after the next meeting of the National People’s Congress Standing Committee. We’re thinking it’ll be about 2 trillion renminbi initially, which is a pretty hefty number. And the idea there is to give local governments some breathing space and enable them to use their cash flow, not for paying back loans, but to pay their employees and to pay their suppliers and get a little more money circulating in the policy -- in the, in the economy. So if all of this works as intended, you know, I think it’s likely over a period of three or four quarters to be reasonably successful at stabilizing growth at somewhere close to the 5% target. But it’s not going to deliver, you know, a big adrenaline shot. It’s meant to sort of keep things from getting worse.
Peter Thal Larsen
And just to -- I mean, just for context here, so 2 trillion RMB is a bit less than $300 billion. It’s a percent and a bit of GDP roughly. And the analogy that everybody always draws is with with the stimulus post 2008, right? Which was 4 trillion yuan. But at the time that was like 12% of GDP.
Arthur Kroeber
Correct.
Peter Thal Larsen
So, and was that much larger. But I just -- one other bit you, we haven’t talked about yet is the stock market. Because we’ve also seen some quite extraordinary measures really by the central bank to sort of create facilities that allow investors and companies to, or encourage investors and companies, to buy stocks. And obviously, the market’s up 20 plus percent since all of this was rolled out. But is this part of the plan or how do you see that fitting into what’s going on?
Arthur Kroeber
Yes. Yeah, sorry, that’s a very good point. And that is definitely part of the plan. So, you know, if you want to be cynical about it, this is, you know, reminiscent of the price keeping operations that the Bank of Japan operated back in the 1990s during Japan’s lost decade. So if you want to put in a negative construction on that, it’s sort of like, okay, here we are again at that kind of failed approach to restore confidence. I think, in China, and we can get into this later if you want, it’s a somewhat different situation than Japan in the 90s. But what they’re trying to do here is the stock market is basically been nonfunctional for the last year. There have been virtually no significant IPOs. And they, I think their primary objective here is to get the stock market vibrant enough so that companies can list and this is important for the long term strategy because the government wants all this investment in high-tech industry. Most of that investment is not coming directly from the government in the form of subsidies. Most of that comes either from bank financing or for capital raising on the capital markets, right. And the capital markets component of this actually has been quite large over the last several years. So it’s a real problem for their industrial policy agenda if they can’t free up the capital markets and enable their favorite companies to, you know, raise more equity there.
Arthur Kroeber
So I think that’s the primary objective. Secondary objective is consumer confidence has really been terrible. The government, I think, does not put consumer confidence at the top of its list of economic indicators they worry about. But, you know, it’s there and the numbers have just been atrocious. And I think there’s a feeling that in order to get consumer confidence going, one thing that you need to do is get some asset price appreciation. So support for the property sector clearly important there. If you can get property prices rising a little bit, households will start to feel better because property is their main store of wealth, and then if equity prices, you know, get into a solid consistent rally again, that should be good for sentiment. Now, I think that the biggest problem for households why they don’t have confidence is their employment and income prospects, which they’re very negative about. So at the end of the day, if you really, really want to get the consumer back in, you have to do things that will improve the employment picture. And I think if you look at the sort of the totality of the project, of the stimulus, they, you know, if it all works, then things should pick up and companies should start hiring more people and it should work. But anyway, I think the stock market is both about funding for industrial policy and for boosting consumer confidence.
Peter Thal Larsen
Yeah, I mean, so we’ve been talking about some of these issues for a very long time, you know, particularly some of the debt problems that had built up in China and the sort of the problem of local government debt and corporate debt and these sort of various kind of entities that were floating around which had sort of accumulated a lot of this borrowing. I mean, there is a sense here a little bit that they are just sort of shuffling money around, right. That you move some of the debt from the local government vehicles to the central government. You move it from somewhere else back to the bank balance sheets and so forth. Is there -- to what extent is this any of this really sort of sorting out some of the past problems of, you know, bad lending?
Arthur Kroeber
Yeah, well, I think you can say it’s, well, I can’t even say that it’s a first step because they’ve done steps before. I mean, the local governments, as you know, you know, started to pile up huge amounts of debt in the aftermath of the 2008 stimulus. There was a round of refinancing in 2015 where they took a very substantial amount of local government debt that was channeled through these off balance sheet vehicles and said, okay, you’re going to make this explicit debt of the local governments. So prior to that, the local governments had not had the legal authority to borrow, then they were given it and they said, okay, you’re going to refinance some of this off balance sheet stuff as on balance sheet, local government debt. And that’s the end. This is the Last Supper and stop, you know, borrowing money. And then what happened was they refinanced all this stuff and then they borrowed more money both through their own bond programs and through the financing vehicles. And so now we’re back with an even bigger problem.
Arthur Kroeber
You know, I think that there are two things that lie behind this, or one thing, really, which is the kind of strange way that the Chinese fiscal system is set up. You know, in most countries, the central government has sort of the primary expenditure responsibilities and the primary revenue raising responsibilities. And then local governments have some part of the expenditure responsibilities and, you know, can raise taxes to support that. In China, basically, the central government controls the large majority of the revenue. Local governments are responsible for almost all of the expenditures, over 80%, right? So there is a mismatch between the local government revenue base and the expenditures that they’re expected to perform. And the way historically that this mismatch was solved was, number one, there was supposed to be transfers from the central government and the problem was that they were very slow. The system is very difficult to make work. And so in a lot of places, the money didn’t arrive in time or it never did or whatever.
Arthur Kroeber
And then the other thing is the local governments earned enormous amounts of money by selling land, basically. And so what has happened is that as the property sector has been restricted by the central government, the local governments have lost about a quarter of their revenues, roughly speaking, they used to get from land. They’re not getting a better transfer flow from the central government. And so unless you’re a place like Shanghai or Guangdong or something like that has a very vibrant, powerful economy, you’re in a real bind and there’s no way out, right? And the flipside of this is that, you know, if you look around at central government borrowing around the world, I mean, the U.S. has got about 100% of GDP, central government debt, most OECD countries are in that range or higher. China’s central government debt to GDP is only 20%, right. So the central government has managed to avoid borrowing any money for, on net, for a very long period of time in a way that is completely disconnected from the actual fiscal realities of the country, which is that they’ve been running, you know, budget deficits, if you account for them properly, of five, six, 7% of GDP for the last ten years, right. And yet the central government debt load has not increased.
Arthur Kroeber
So there’s this kind of weird way that they’ve set things up. And the way to solve this is, number one, is to recognize the reality that has been apparent to everyone for many years, that a lot of this so-called local government debt, which local governments never had the revenue basis to finance, is really sovereign debt. The local governments are doing things central government wants them to do, and the central government is somehow pretending that it’s not their responsibility to finance. And that’s frankly ridiculous. So the simple act of recognizing some of this so-called local debt for what it really is, which is central government debt, I think is an important step to sort of fiscal realism. At a more practical level in what they will able to do is cut the interest rate on this debt, because the central government debt is now running at around, you know, 2%, um, most of the local government debt was borrowed at higher interest rates. So if you do this refinancing, it will significantly improve the cash flows of the consolidated government. So that’s a good step. But at the end of the day, if you really, really want to solve this problem, you need to go back and look at the whole fiscal arrangements and say, okay, what is it reasonable to ask local governments to do and where’s the revenue going to come from to do that? And there are no good answers to that. So, summary on this is I think it’s a good step. They’re kind of moving slowly in the right direction, but there’s a lot of work that is just not done yet.
Peter Thal Larsen
Yeah. So just coming back to property, which you mentioned a couple of times, I mean, there was this dynamic where the local governments sold land to property developers who then developed it, built lots of property, borrowed lots of money to build lots of property. And this was a big part of China’s economic growth for that period after 2008. And obviously, then the central government said, okay, this has gone too far and sort of began to rein in the property developers and so forth. So there’s two problems really, it seems like one is just as a proportion of economic growth, it’s, the property sector has become smaller. And from what you’re saying, there’s no real plans to increase that. But then there’s still this overhang, right, because people have bought property which has fallen in value. There’s lots of empty property. You keep reading about sort of ghost cities and stuff. I mean, to what extent do they need to find a solution for that overhang?
Arthur Kroeber
Yeah. Well, I think there’s two ways that you can think about that. One is if you look at property transactions and divide them into primary and secondary, so primary is developers building new stuff and selling it directly to the first buyer, right? And secondary is, you know, pre-owned housing that is being bought and sold, you know, in private transactions, right. Secondary housing sales have been very robust for the last 18 months. So they’ve, in fact, been growing steadily. And and what that suggests is that there is actually quite a bit of demand among households for housing, which makes sense. The urban population is still growing. You still need to, you know, house people, etc. And one of the characteristics as far as we can tell of the secondary market is that prices have fallen quite a bit more in the secondary market than in the primary one, right. So you can make the argument that, okay, what’s going on here is that prices have been allowed to adjust in the sort of more market driven part of the housing sector and now sales are picking up. So in the primary market, what you need to do is allow prices to fall more until they hit some clearing level, and then people will be back into the market. And so eventually you can soak up some of the inventory there by just letting prices break. And what’s happened is that local governments have been unwilling to let the primary prices fall as much because they have a lot of debt that’s collateralized on land values and so forth. And they would have to recognize losses if they permitted this to happen. So there’s a lot of administrative interference in that sector of the market, okay. So that’s one way of looking at it, is that you just need a price correction. And if that’s the case, the fact that they still have not really allowed those prices to fall or create a mechanism for that is a problem. And so you’re going to you know, the pain will be extended, right?
Arthur Kroeber
The other way of looking at it is the main thing that is obstructing people from buying property in the primary market is, you know, typically the way you do it is you put some money down for an apartment that is not started or not complete yet. And then the developer completes it. But then if you have no confidence that the developer will complete it, why would you ever put money down? And that’s, you know, I think that’s a pretty good description of what’s going on. So I think the government’s strategy on this is to say, okay, we are really, really going to put a lot of money into helping developers finish these uncompleted projects so that they can go to market. If the developers are just like not available or completely bankrupt, then we will finance local governments to purchase this property and then either resell it or make it into affordable rental housing or something like that. So we’ll have a government as a buyer component of this this program, and that will unstick it.
Arthur Kroeber
And I think my judgment would be that, yes, you have these inventories and there are some cities where there’s just a lot of stuff, you know, unsold housing that probably never will be sold. And it will kind of rot away and it will be a, you know, a testament to the, you know, the excesses of the the 20 teens. But if they can, if they can solve these other problems either by allowing prices to clear or by solving the, you know, the completions problem, at the end of the day, I think there’s enough demand that they can keep things, keep things going and kind of restore, you know, some vitality to the property market. So I, you know, I think bottom line is they’re going to have to accept that some of this stuff that got built, probably just a dead weight loss. But it is possible to, I think, address the problems of the property market without, you know, finding a buyer for every single piece of property that’s been built.
Peter Thal Larsen
And I guess also key to restoring confidence.
Arthur Kroeber
Yeah.
Peter Thal Larsen
I just want to -- just looking forward a bit. You said at the outset, you know, contrary to what a lot of people seem to think, this is not a plan about stimulating consumption or sort of shifting China to a more consumption-based economy in the future. That seems to be, a lot of the discussion is about, well, they depended too much on the property sector and on infrastructure and historically on exports. And now where’s the growth going to come from in future? But if the plan is to sort of, as you say, to, and as the Chinese authorities say, to focus on high-value manufacturing and presumably exporting the results of some of that high manufacturing, as we’ve seen with batteries and electric vehicles. I mean, how realistic is that, given the sort of, the shape of the Chinese economy and given the shape of the world economy, and we’re already seeing pushback on electric vehicles. Is that realistic?
Arthur Kroeber
Well, yes and no. So, my basic vision of what China is going to turn into over the next, say, five to 10 years is a high-tech, low-growth economy. So they’re very successful at what they do. They have a manufacturing ecosystem that is terrific. You have, a lot of it is essentially private companies that are very entrepreneurial, very good at keeping costs under control and very good at process improvements to make their stuff better. And the electric vehicles, I think, is a terrific example of that. But you could multiply them across many, many sectors of the manufacturing economy. So the --
Peter Thal Larsen
And also benefiting from subsidies from government --
Arthur Kroeber
Yeah, right, no for sure, for sure they’re definitely doing that. But it’s like, I think my sort of take on this is that people focus on the subsidies, and that’s part of the equation, but if it were just subsidies, you would not have seen the kind of success that, you know -- purely subsidized companies do not enjoy the success that a company like BYD does. You know, when they sell in export markets, you know, people don’t care where their money comes -- they just care, is this a good car? And I think the evidence is people say: this is a good car. You can look at DJI in drones. China is now the biggest producer of industrial robots in the world and they’ve been steadily climbing up the value chain. So you can look at sector after sector. And yes, there has been subsidy support, but there also has been steady technological improvement, which has been driven by the competitive nature of the domestic market and the fact that at the end of the day, a lot of these people do have to sell on export markets where it’s not just about the cost. The quality has to be there, too, right. So it’s, so it’s both.
Arthur Kroeber
So I think the momentum behind a lot of this manufacturing success is very strong and can continue, right. So that’s the, that’s the good part, the high-tech part. And I guess the other thing I would say is there, yeah, you’re getting a lot of protectionist noises. So far, this has not translated into anything that really hurts Chinese manufacturers. Now, that could change, right. If you get more and more protectionist pressure. But the reality is that you’ve had a lot of protectionist actions and China’s global export market share just continues to rise because they’re very good at what they do. So there are some concerns there, and obviously, I think if Trump comes in and we have 60% tariffs on everything coming from China, that will be very difficult for them to deal with.
Arthur Kroeber
So -- but anyway, that’s the good part of the economy. The problem is that essentially they are investing, you know, their whole growth strategy is to invest massively on the supply side. And their theory is that over time, this generates a lot of productivity growth. Productivity growth translates into good jobs, high wages, incomes grow, and you get not just a strong supply side, but you also get a strong demand side of the economy down the road. And that’s where I lose the plot. I just don’t see the linkage there because, you know, one way of looking this is like, 60% or so of employment in the economy is now services, that share is inexorably rising. The number of workers who are in these high-tech industries is a very, very small proportion of the total. So yeah, you can get very good at making industrial robots and semiconductors and whatnot, and the workers in those industries can be very well paid. But what does that do for the, like, large majority of people outside in the rest of the economy? It’s not at all clear.
Arthur Kroeber
And my take on this is that if you want economy wide productivity benefits, you do need to focus more on the demand side. You need to get more juice into consumer services because that’s where most people, frankly, are going to be working and they just don’t seem to be very interested in that. And so the result is, and you’ve seen this very clearly over the last several quarters, is that you have a very deflationary environment. China now has had deflation, in terms of declines in the overall price level for six consecutive quarters, as you are always increasing the supply side faster than the demand side. You know, and I think what we know is that once deflation becomes entrenched, it’s very, very difficult to get out of it. And one of the worrying things is that if you look at this suite of policies that they have come out with over the last six weeks, which is pretty impressive in a lot of ways, there is, except from the central bank, there’s very, very little discussion about deflation as a problem that needs to be solved. The central bank gets it, they have been very clear about that. And so they will do what they can, but you need sort of broader policies, and it’s not clear that that’s going to happen. So, yeah, I think China will be very successful, high-tech. I think they will be able to maneuver around the protectionist pressures, but that is not going to generate really high rates of growth in the domestic economy. And I think it’s probably going to slide, you know, further from around 5% to, you know, 4% or maybe even lower over the next two years.
Peter Thal Larsen
Yeah. And which -- when you’ve got a high debt level, obviously, that’s, that’s a real problem.
Arthur Kroeber
And that is, that is a problem that makes that much harder to solve.
Peter Thal Larsen
So that kind of brings up -- maybe this is a good place to finish up is, this brings us back to the analogy with Japan, which you mentioned earlier, and we’ve always read these things about how the Chinese Communist Party is obsessed with the example of Japan and studies it at great length, and will -- is really intent on avoiding the mistakes that Japan made that led to those two lost decades. And yet some of the things you’re describing now seem like they are repeating those mistakes. So, I mean, is that really the concern, or is there still a sense of trying to avoid that?
Arthur Kroeber
Yeah, well, I would say, you know, they are -- the reason for that contradiction is that on the one hand, yeah, they have devoted a lot of effort to understanding the disasters that befell Japan, but also the disasters that felled the Soviet Union in the 1990s. And they say, okay, these are the big mistakes of economies, which are sort of relevant comparisons for us, and we’re not going to repeat those, right. But they have the same mental framework that they’ve inherited, both in some ways from Japan and from the Soviet Union, which is -- so, on the Japan side, it’s all about, you know, export led growth and technology as the solution to everything and not really much of a recognition of the demand side, domestic demand side of the economy, as part of the motor of innovation and growth, right? They really, really are stuck in this idea that the way you get innovation and technological upgrading is through improvements among producers. And the consumer input into this is just not all that important, right. And obviously, the United States is the opposite example of this, where we think everything is driven by consumer demand. There’s a lot of reality to that, right.
Arthur Kroeber
So they’ve inherited that sort of basic construct from sort of the East Asian model of growth that Japan pioneered. They’ve also, because Xi Jinping is a little bit of a Marxist, he’s inherited a very materialist, production oriented mentality from the Soviet Union, right. So if it’s not physical, if I can’t touch it, it’s not real. And, you know, he has a kind of a Leninist view that the government really needs to guide everything. So, yeah, they, despite their best intentions, they, I think, are at real risk of falling into some of the problems that beset Japan in the 90s.
Arthur Kroeber
So I would say that’s a significant risk, but it’s not yet a reality. And I think it is worth underscoring the ways in which China is a very, very different construct than Japan. So first of all, both countries had a property bubble, but they were not the same. The Japanese property bubble was just fantastic in terms of the asset prices. And it was literally the case in the late 80s that often you would buy Japanese companies, their equities, not because of what the company was doing, but because the value of the land they sat on top of that was in their balance sheet. And that just is not true in China. So that the extent of the property bubble and the rise in asset prices in Japan, both land and equity prices, it was just stratospheric. And China has had nothing like that kind of asset price bubble. So the amount -- the asset price bubble that China has to deflate is much, much smaller than the Japanese.
Arthur Kroeber
That’s, I think, difference number one. Difference number two is that Japan, and I’m simplifying here, but Japan had essentially a unified national balance sheet because there were cross shareholdings between financial companies, banks and industrial companies. So they all owned each other’s stock, all of that -- those equity holdings was collateralized on land values that were just way too high. And so when asset prices started to deflate, every single sector of the economy was affected and everyone got into sort of like paying down debt. And so therefore, you got the classic, you know, balance sheet recession. China has a fragmented balance sheet. They’ve never permitted these cross shareholdings, partly because of the experience of Japan. So, yeah, there are parts of the economy that are, have really bad balance sheets, the property sector and the local government financing vehicles, they’re terrible. But you look at the manufacturing side of the economy, and it’s basically fine. They’ve actually been reducing leverage over the last decade. They’re not overextended. There’s too much capacity, and so everyone’s operating on thin profit margins and there needs to be a shakeout. But you don’t have a balance sheet problem in most of the industrial sector. So that’s a very big difference.
Arthur Kroeber
And then the third thing I would point to is just in terms of production structure. One of the things that sort of made things particularly hard for Japan in the 1990s is they had created a very, very successful economy built around building stuff for a non networked world, right? And then when the internet came along and the world became all about networks and the services that you build on top of those networks, Japan was just not able to compete in that globally, right? So they missed an important trick in sort of technological development. And that, you know, if you look at today, the obvious analogy is what’s the next big thing? The next big thing clearly is everything related to the green energy transition. And China is actually a leader. And so they, I think, have some real advantages relative to Japan over 1990s that mean that if they run competent macro policy, they should be able to do better. And the missing link I would say in the macro policy at the moment is the recognition that deflation and price declines are really a central problem. And they need to attack that much more forcefully, you know, through some combination of fiscal and consumer activity, that may come, but as long as they avoid that part of it, then I think although they have a lot of advantages relative to Japan in the 1990s, I think there is a risk that they sort of gradually slide into a similar dynamic, not today or tomorrow, but over a period of years.
Peter Thal Larsen
Yeah. And would do so with a sort of much lower level of prosperity --
Arthur Kroeber
At a much lower level --
Peter Thal Larsen
Than Japan did, when it got into that position.
Arthur Kroeber
Right, exactly. And so that raises, you know, some serious concerns about, are they able to keep the population happy.
Peter Thal Larsen
Yep. Arthur, this has been terrific. We could talk about this for hours, but we have limited time. So I think we’ll have to stop there. But thank you so much for coming on and for giving us the benefits of your perspective on this. And I’m sure we’ll come back and talk about this again at some point soon.
Arthur Kroeber
Yeah, it was great. Thank you so much.
Peter Thal Larsen
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