Is China facing a Japanese future?

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So it’s official. China has become the second-largest economy in the world, overtaking Japan. Based on Japan’s 2010 GDP results, released on Monday, China’s economy is about 7% bigger. China’s ascension to No.2 (behind the U.S.) is yet another sign of the shifting fortunes of Asia’s two great economic powers, and yet another milestone in China’s march to superpower status. Japan was once the roaring tiger of Asia, but for the last 20 years, it has been trapped in an economic funk that has eaten away at its global influence. Now China, routinely defying gravity with 10%-plus growth rates, has replaced Japan as the premier symbol of a rising East.

What is more interesting, though, is the fact that China today is using similar policies and practices to climb up the charts of the world’s biggest economies that Japan employed during its go-go years. Both countries are “state capitalists,” which mix government control and free enterprise to produce rapid economic growth and industrial development. But as the case of Japan shows, that “state capitalist” system has as many flaws and dangers as benefits. The same system that drove Japan’s economic miracle ended up dooming the economy. Thus the big questions facing China are: Will Beijing’s version of state capitalism triumph where Japan’s has failed? Can China avoid Japan’s fate?

Japan was, in fact, the original Asian state capitalist. It started devising its state-led system back in the 19th century, and the model really hit its stride from the 1950s to the 1970s, when Japan produced China-style growth rates. Industrious bureaucrats determined how resources would get allocated in the economy by “picking winners” – selecting favored industries – then ensuring the banks funneled money to the preferred companies and projects. Though the government didn’t own many of the banks, it effectively controlled their lending practices. Large domestic savings was shoved into industrial investment. The system generated giant current account surpluses by promoting exports at the expense of domestic consumption, and Japan was accused of keeping the yen artificially cheap to keep its exports extra competitive. Not only did Japan’s state capitalism produce remarkably rapid growth, it also fostered new, globally competitive industries, such as steel and semiconductors. Back in the 1970s and 1980s, it was popular in the U.S. to believe that Japan had created a superior economic model to that of the West, better able to absorb shocks, preserve growth and jobs during downturns and promote future industries. Some experts advocated that the U.S. needed to copy Japanese methods in order to compete.

China is following the same pattern. China’s government directs lending through a state-owned banking system to “pillar” industries, including steel and automobile manufacturing. The bureaucrats help develop new industries, like green energy, though special financial support. China runs up huge surpluses by keeping its currency super cheap to promote exports. Chinese consumers tend to be savers, not spenders, and the economy grows through investment. And there is no shortage of pundits, businessmen and journalists who have become enraptured by China’s “state capitalism” in the same way they once were with Japan’s. While the U.S. and the euro zone struggle to maintain competitiveness and create employment, China is busily investing in the industries of the future and securing stores of natural resources around the world. The implied argument here is that the U.S. has to become more Chinese – to turn “state capitalist” and match China’s industrial policies in order to compete in the future – just as it once had to become more Japanese.

Yet the Asian state capitalist system also has inherent flaws – flaws that in the case of Japan proved to be its undoing. The way in which Japanese state capitalism worked was to lower the cost and risk of industrial investment, but that practice at the same time skewed the incentive structure within the Japanese economy, resulting in excess capacity. Bureaucratic meddling, combined with tight ties between government, business and banking, created a financial system that allocated funds based on government preferences or personal relationships. In other words, the economy didn’t operate on clear “rules” based on credit risk or corporate governance. Eventually, the Japanese state capitalist system collapsed into crisis. Policymakers desperate to maintain soaring growth rates kept money too cheap for too long and inflated a stock-and-property bubble in the late 1980s. After it burst, debt-heavy companies with too much capacity that had lived on the easy-credit gravy train became incapacitated. These “zombie” companies represented the excess investment and capacity that probably had no reason to exist in the first place. The financial sector was left a ruined wasteland.

Other countries that copied aspects of the Japanese system faced the same disasters. South Korea employed a very similar model to Japan’s beginning in the 1960s, with similar results – incredibly high growth and the emergence of globally competitive industries, like shipbuilding. But Korea’s policies created similar problems to those in Japan, and the entire system broke down in the 1997 Asian financial crisis. Bank lending influenced by government preferences and historical personal connections had created what could be called a “factory bubble,” in which firms invested in industrial capacity way out of line with reality. When the crisis hit, the corporate system collapsed under its debts. The most famous case was Daewoo, which built car factory after car factory for buyers that didn’t exist. It went under in 1999.

The bottom line here is that Asian state capitalism generated some strong years of growth, created jobs and eliminated poverty, but also planted the seeds of its future destruction. What happened is that the state so altered the rules within the economy that investment became disassociated from risk. State capitalism resulted in the misallocation of resources that eventually was corrected at great cost.

There is good reason to at least ask if China is getting itself into the same mess today. The state capitalist system in China is arguably creating the same debt-driven excess capacity that got Japan and Korea into trouble. The Chinese government itself complains that there is too much capacity in certain industries like steel. There are clearly close links between government, finance and business in China — many companies and banks are outright owned by the state, and state banks often lend to state companies. Easy money aimed at propping up growth is fueling a giant surge in property investment and prices. What’s happening? Loose money, directed lending and government support is twisting the incentives in the economy in ways that may be propelling the rapid advancement of industry, but also may be misallocating resources and inflating asset bubbles. In other words, China’s state capitalism is destroying the concept of risk just as it did in Japan and Korea.

Of course, this doesn’t mean China will have an economic crisis. There is an argument out there that China is “different” — its home economy is so big that it can support all of the stuff being built. China is also aware of the dangers its economic model is producing, and is proactively trying to reduce the economy’s dependence on investment by encouraging consumer spending. Such reform will prove crucial if China is to avoid the traps that caught Korea and Japan. Japan’s economy has been in the doldrums for 20 years because it has been unwilling to reform its state capitalist model enough to fix the problems that system created. The reason why South Korea is doing better is because the state has been receding from the economy, which is becoming freer and more open. In other words, Korea is emerging from the rubble of its state capitalist practices by shedding those practices and becoming more “Western” in its capitalism.

So the big issue facing China over the next 10 to 20 years is whether Beijing can maintain the benefits of state capitalism (high growth, rapid industrial progress) while avoiding or resolving the costs (misallocation of resources, excess capacity, asset bubbles). Now that China has overtaken Japan using Japanese economic techniques, China should learn something from the reasons Japan has fallen behind.