Open QuestionsEconomist Richard Koo on China and Japan’s shared ‘battle against time’

Nomura Research Institute chief economist Richard Koo is well-known for his “balance sheet recession” interpretation of Japan’s economic downfall in the 1990s. In his second Open Questions interview, Koo assesses the risks the Chinese economy is facing this year and beyond, the many parallels between Beijing and Tokyo, and why market size and technology alone may not be enough to help avert a fate similar to Japan’s. Koo also explains why giving China’s consumers money will not help and why complacency in the face of energy supply and economic disruptions from the conflict in the Middle East is a cause for concern. This interview first appeared in SCMP Plus. For other interviews in the Open Questions series, click here. China’s gross domestic product growth hit 5 per cent last year and in the first quarter of this year, but growth seems to have cooled since April. Do you think the risks of a balance sheet recession are lower or still heightened? Is China in or out of a possible Japanification spiral? When you hear about so many difficulties Chinese companies are having, this 5 per cent number seems very optimistic. Maybe if you just look at the production side, there is 5 per cent growth, but for GDP you have to view both sides: production and expenditure. We don’t have enough expenditure and consumption. As for whether China is coming out of Japanification problems, one thing I watch carefully is the 10-year government bond yield in China, which is about 1.7 to 1.8 per cent. That’s a ridiculously low rate for a country which supposedly has plenty of domestic investment opportunities. Such a low yield means many people are not borrowing money, or, rather, they are merely paying down debt. And in that case, financial institutions that are flooded with inflows of savings from the private sector often have no choice but to lend to the government because it is the only borrower left. The situation for Japan was that the government bond yield started from 8 per cent at the peak of the bubble in 1990 but dropped all the way down to 1.7 per cent by 1997. Those record low yields were the bond market’s messages telling the government that this is no time to cut deficits. At that time, many experts from around the world ignored that message from the bond market and gave the then Japanese prime minister Ryutaro Hashimoto the wrong advice. They said given the size of Japan’s budget deficit, there would soon be a fiscal crisis if the government failed to reduce its deficit. My advice for the government to borrow and spend was also ignored. The Japanese government instead tried to rein in spending and cut its deficit, and then the economy collapsed. Japan had five consecutive quarters of negative growth and a complete meltdown in the banking system. That was in Japan in 1997, and today the Chinese government bond yield is also 1.7 per cent. And China today looks a lot like Japan in 1997. Furthermore, getting out of a deflationary cycle is a battle against time. If China makes a mistake, as Hashimoto did in that period, China could still fall into a deflationary spiral, as Japan did. So judging from the bond market, which doesn’t lie to you, I don’t think China is out of the woods yet. China may still be struggling. You don’t get a 1.7 per cent government bond yield if you’re not in a balance sheet recession. Getting out of such a recession is a battle against time. Many regional governments in China don’t have enough money to pay their workers. Many bureaucrats are facing pay cuts. This is not a very good sign. I’m sure some households and companies in China have clean and presentable balance sheets, especially those who were not heavily involved in the property bubble. I’m sure there are some companies and households that are feeling OK now. But the question is whether they are the majority or not. If the Chinese economy is operating normally, then we should see that in the bond market and higher yields. I will be watching the markets more carefully instead of just looking at macro numbers. Many Chinese economists disagree with the comparison with Japan, saying China has room to manoeuvre with its enormous market, urbanisation and rising tech strength. What do you think? These are not enough to help China avoid Japanification. If you go back to the 1990s, Japan was also at the top of the world. Japan also had the technology and it was also the world’s second-largest economy throughout the 1990s. Back then Americans were also very envious that Japan was taking over all their industries, from autos and electronic appliances to computers and semiconductors. All these were not enough to pull Japan out of a balance sheet recession. There were two reasons for that. One was that in a balance sheet recession domestic demand is constrained from the very beginning. For households or companies that borrowed tons of money during the bubble years, when the bubble burst their debt was still there but their balance sheet was under water. You have to come out of that as quickly as possible. So households and companies are likely to set aside a certain amount of money to pay down debt as quickly as possible. Let’s say that’s 10 per cent of their income. Then they only have the remaining 90 per cent of their income to spend on investment or consumption. That means only 90 per cent of the income returns to the economy’s income cycle each year, resulting in the economy shrinking 10 per cent per year. This is the reason why I said fighting balance sheet recession is a fight against time. Now in China, all these technological developments and the competition among Chinese companies – and some of them are very good companies – is a race to capture that 90 per cent. There is also the difference between macro and micro. If you look at micro levels, some Chinese companies are doing a fantastic job. But on the macro level, there is a 10 per cent leakage in the income stream because companies and households want to repair their balance sheets. So, China’s tech and massive market alone may not be enough to help China avoid this fate. The second reason is that the private sector as a whole cannot be relied on as a source of growth, because they all want to repair their balance sheets. So only two drivers are left: the government, and exports – which rely on external demand. Luckily, the Japanese government back then did borrow and spend a lot of money, so its GDP never went below the peak of the bubble. On the export side, meanwhile, Japan had the largest trade surplus in the world at that time, just like China today. Americans were very upset with Japan’s trade surplus – Europeans too. There was also a trade war back then. I was in the middle of it. In front of Japanese television audiences, I had to represent the United States’ trade positions, as requested by the American ambassador to Japan, Walter Mondale, who was vice-president in the Jimmy Carter administration. I was asked to explain US trade positions in the middle of the ugliest trade war since World War II. I got bashed. I got death threats. I learned a lot about trade during the process and how ugly, nationalistic and racist we can get. So Japan fully realised that relying on exports was not an option, even though Japan made the best products in the world at that time and everyone wanted to buy Japanese cars, cameras, home appliances and so on. But still, Japan could not push exports too hard, or other countries would start putting up barriers. China is in exactly the same position today. I hope that China will not push this too far. Maybe some countries in Southeast Asia or Africa are fine with that. If you drive exports too much, once you reach a certain threshold, people in the West will get very upset, then you lose those markets and you are left with only poorer markets. Now, even with a huge Chinese trade surplus, what is happening to the profits of Chinese companies? Razor-thin margins when they can no longer sell as much as they want to rich markets. The bottom line is that China trying to export its way out of its economic problems would be a very risky strategy. At some point, people in other countries would say enough is enough. Let me also say something about deflation. This deflation in China that so many people talk about, especially compared with Japan’s in the past 40 years or so, is, in my view, a result, not the cause, of the problem. Everybody is paying down their debt and then the economy becomes weak. A lot of people say that when there is deflation, people postpone their purchases and therefore the economy is weak. That does not make sense to me. And since this notion has become so pervasive, especially in Western academic circles, many people say that if the Bank of Japan (BOJ) had started printing money, everything would otherwise have been fine. The BOJ believed in that argument and did precisely that, despite my advice against it. It printed money like crazy. The amount of bank reserves in Japan almost reached 80 per cent of Japan’s nominal GDP. But Japan’s GDP or inflation rate hardly responded, because people were not borrowing money, even though money was there. So banks were flooded with reserves because the BOJ gave it to them, but they could not find any people to lend to. The money could not leave the banking system and go out into the real economy, which is why Japan’s inflation rate kept on missing the 2 per cent target until the end of the pandemic. They increased the monetary base so much, but the inflation rate never picked up. The reason that happened is because Japanese people were not borrowing money. So price indicators like deflation are, in my view, lagging indicators. It’s a result instead of the cause. Economic growth is very much dependent on people’s willingness to borrow There is data showing Chinese households have been repairing balance sheets. Some cities also report a rebound in property prices and transactions. Are households and the property sector now out of the woods? In China’s case, the government is now trying to stop companies from cutting prices – what is known as involution-style competition. So if the government issues directives, at least on the surface, companies who don’t want to be punished will keep prices from falling. But that doesn’t mean people are actually buying at those prices. People are still not buying. They are still paying back debt. So I won’t get too excited when prices are stabilising. What really matters here is to see people actually borrow and spend money. Borrowing money is very important here because if you think about economic growth, it means someone is spending more money than he earns. If he spent exactly what he earned, the economy would be stable but it wouldn’t grow. Economic growth is very much dependent on people’s willingness to borrow. If the economy has good future prospects and if people are optimistic, then the bond yield should probably be 3 to 4 per cent. Chinese consumers remain timid, with increases in retail sales lagging headline GDP growth. What is holding Beijing back from rolling out more substantive policies to boost demand? Would dampened consumer sentiment, lack of demand and price wars be the most likely trigger for a potential balance sheet recession? I am not in the camp of those people who say give money to consumers so they can spend more. The reason is that if you give them money, like tax breaks, consumption vouchers, whatever, my guess is that people will use that to pay down debt first. Their balance sheets will be better than before, but the economy will not improve. And if the economy does not improve, the consumption situation will get worse. I’m one of the very few people proposing that the government should take the lead and spend money directly, instead of pinning any hope on Chinese consumers. Instead of giving resources to consumers or companies, the government should spend them. Let’s say I have US$1,000 of income and I spend US$900 myself and save US$100. In ordinary situations, the US$100 will go to financial institutions and the latter will then lend it to someone who can use it, with total expenditure equal to the original income. And if there are too many borrowers, the central bank can raise rates; if too few borrowers, the central bank will lower rates to make sure that all the funds, like the US$100, will be borrowed and spent. Under ordinary circumstances, I would say, yes, tax cuts would be great, but when the private sector is minimising debt, you do not give them tax cuts. For the government to spend money, it does not have to be buildings or infrastructure, it can be any projects that the government spends money on that can generate a social rate of return higher than 1.7 per cent, because these projects can become self-financing and sustainable and are not going to be a burden for taxpayers. For example, such investment can even be programmes to improve English education in Chinese schools. It may have a social rate of return higher than 1.7 per cent. If I were in President Xi Jinping’s position, I would bring all of China’s brightest people into one room and let them discuss and come up with those social projects. The government should keep doing this until balance sheets are repaired, the private sector is willing to borrow money again, and this deflationary issue is behind us. US President Donald Trump visited China again in May. How has this affected the bilateral relationship? Is the tariff war over? Trump and Xi Jinping met in South Korea in October, which went relatively well. From America’s perspective, China agreed to delay rare earth restrictions, buy soybeans and tackle the fentanyl issue. If those agreements are implemented, there should not be too many issues still left unaddressed. It will not be as bad as a year ago, when the two countries were fighting each other. I find it very odd that this time, the US government asked the Chinese to tell the Iranian foreign minister, who visited Beijing right before Trump’s trip, to open up the Strait of Hormuz. It looked like the American government was begging Beijing for help. I think Washington is realising that it does not have much leverage. They’re begging the Chinese for help because of all the mess that Trump has created. It’s already showing who has the upper hand. But you know, for Trump, he may beg you for help one day but two days later, when something else happens, he will bash you. I’m sure Chinese negotiators understand that, and will not put all their eggs in one basket, just because one day Trump begged them for help. Geopolitical turmoil is spiking, marked by the war in the Middle East and the Strait of Hormuz crisis choking global supply chains. Do you agree China has managed to stave off shocks better than others? If China has done better than other countries, one of the reasons is that China is buying Russian oil, equalling about 15 to 20 per cent of Chinese consumption. Other countries are not doing so because they are so upset with what Russia has done to Ukraine. And then the blockade of Hormuz happened and people got squeezed. I’m sure, given current conditions in the Middle East, that China can buy more and Russians would be happy to sell more. Trump may acquiesce to such an arrangement because that will keep world oil prices down. So that puts China in a different category as far as how they are dealing with this oil issue. Unlike other places, China has no political resistance to Russia. The energy shock from the Iran war has raised worries about the global economy, and some have compared it to the 1970s crises. How bad is it? How will this redraw the global economic landscape, especially when China is a leader in new energy? I must say, on this issue, China is probably better prepared in the sense that China has put a lot of effort into renewables: solar, wind, electric vehicles and so on. That is a kind of cushion against what is happening in the Middle East now, plus China has access to Russian oil and gas. Unfortunately, what Trump is doing is the opposite. Some Asian countries, like Japan and the Philippines, have very little in the way of energy resources and, of course, they will be suffering more than others. As for the global economy, I’m afraid something like the 1970s crises may happen. Back then there were two oil shocks – in 1973 and 1979. Today, a lot of countries have strategic reserves, and those reserves have kept their economies going, for now. But that is the kind of complacency I see. When so many countries are supposed to be facing a big oil crisis, stock markets are still doing so well. I find this rather ironic. I think stock markets and other markets should be more concerned. When the US is weaponising the dollar, many other countries begin to worry The yuan’s internationalisation appears to be accelerating. In your view, what stage is it at now and what are the major hurdles? Chinese currency internationalisation was a big issue about 15 years ago. I remember there was a bit of enthusiasm there. Beijing suddenly realised that, given political and other issues, if you internationalise the yuan then you lose control of the capital account. And not only that, they got so worried that the money that flowed out of China would be bigger than the money that came in. Now why are they talking about this internationalisation again today? Because the US started weaponising the dollar. Many global trade transactions are done in US dollars, and they have to go through American banks at some point. When the US is weaponising the dollar, many other countries begin to worry that if you rely on US dollars, and, suppose Trump doesn’t like you, he might cut you off from the banking flows. So my guess is that internationalisation of the Chinese yuan is coming up, not because the other problems are resolved but because there is a new problem of the US government weaponising the dollar. We should compare the yuan’s internationalisation with what happened to the Japanese yen in the 1990s, when Tokyo was also trying to internationalise its currency. I was also involved in the debate at the time. If you want to internationalise your currency, your market will have to be very open. But the Japanese market back then was not as open as it should have been. Suppose you were a Malaysian company and you assembled DVD players and shipped them to the US. Your parts came from Japan, with the final customers in America, so your final earnings were in US dollars. That’s why Japan could not internationalise the yen. If Japan’s markets had been very open, with such traders being able to buy components from Japan in Japanese yen and also being able to sell their products in Japan for yen, the country would not have faced exchange risks and the yen would have become more internationalised by the mid-1990s. But just because Japan would not buy things from other countries like Malaysia – only Americans would buy from other countries – the yen internationalisation failed. That is despite the fact that the Japanese government put a lot of effort at that time into internationalising the yen. But at the most fundamental level, its market was not open. So by the same token, China faces the same challenge, the same dilemma. If the Chinese market is truly open and highly predictable, it will be automatic for the yuan to become more internationally accepted. People will say, please invoice this thing in Chinese yuan because they will buy components from China, assemble goods and ship them back to China. They, naturally, want both sides of the transaction to be in the same currency. But Beijing will not easily open up its market. So that’s the fundamental issue and the fundamental barrier, just like with Japan. The tensions between China and Japan have shown no signs of easing and may even spill over to trade. Are you concerned about the impact on both countries’ economies if Beijing and Tokyo fail to mend ties? I’m sure this is not good for companies in both Japan and China. But you might have noticed that some foreign companies are less attracted to the Chinese market. They have exited China and the reason is quite simple: they were not doing well in the country and there were oversupply issues. Some of those that still have big operations in China are not making money either. The tensions, this time, may be different. Until about 10 years ago, if there were political tensions between China and Japan, Japanese companies with investments in China would have been urging Japanese politicians to resolve problems for the sake of their big investments in China. Politicians would agree. But now, it’s different, because some of these companies are already trying to leave China or have already left. They have divested. So there are fewer voices today that can keep the two countries together. The economic relationship is actually weaker. Japanese companies are already having so much difficulty in China and they are now under even more pressure due to the diplomatic issues. More will be leaving China as a result. If Japanese companies start leaving, that will perhaps hurt the Chinese economy more than the Japanese economy, because Chinese companies are already very cautious and if the Japanese start leaving, who is going to employ all the laid-off workers and who is going to fill the void? So if I were the Chinese government, I’d be very worried. Because compared to 10 years ago, the situation is dramatically different in the way foreign companies look at the Chinese economy and its market. Ten years ago, they would do anything to enter the Chinese market. Now, some of them are doing everything to leave. When the economy is facing strains, you do not want to make things even worse.

.css-1c6uqr6{color:inherit;font-weight:inherit;font-size:inherit;font-family:inherit;line-height:inherit;overflow-wrap:break-word;}China has strong tech industries and a large market – but so did Japan before its recession, warns the Nomura Research Institute scholar

China has strong tech industries and a large market – but so did Japan before its recession, warns the Nomura Research Institute scholar