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Twenty-five years ago, I heard a clutch of top American financial officials, including Timothy Geithner and Lawrence Summers, offer advice to their Japanese counterparts about how to tackle a property crisis.
The essence of their message revolved around two words: “clearing prices”. As Japan reeled from the collapse of the 1980s property bubble, US officials urged its government to inject transparency into the market — and bank balance sheets — by trading bad assets in a way that would establish a “floor” for their values.
After all, they noted, that was how America exited its own 1980s Savings and Loans crisis: it auctioned bad loans via a Resolution and Trust Corporation, in a way that pulled opportunistic investors back into the market, and (re)built confidence in asset values.
As it happened, the Japanese did not initially heed that advice. Nor did Washington when its own great financial crisis first started more than a decade later.
On the contrary, US officials wasted months denying the scale of their subprime mortgage losses, prompting Japanese officials to complain to me — with justifiable irritation — that the Americans were refusing to take the harsh medicine they had prescribed for others.
No doubt future historians will write books about the irony of this, and note that it was only when Washington finally tried to create clearing prices, in late 2008, that the system began to heal.
However, the key question now, as markets reel from the implosion of the Evergrande property group, is whether the Chinese authorities will become any wiser (or less dumb) in 2024 than their Japanese counterparts in 1997, or the Americans in 2007?
After all, in some ways China’s challenges echo 1990s Japan: a bank-centred financial system is becoming more focused on capital markets; a maturing economy is shifting its reliance from industry to services; bad demographics are threatening future expansion; and a deflating bubble has created a mountain of bad loans, totalling Rmb3.2tn, according to official data, that almost certainly understates the problem.
Thankfully, China has policy buffers that could make this easier to tackle than in Japan: the government has vast financial resources, tight(ish) control over the economy, a highly entrepreneurial private sector and thoughtful bureaucrats. (To illustrate the last point: after my book on Japan’s “trillion-dollar meltdown” was published, Chinese officials contacted me keen to learn the lessons from history.)
However, as Goldman Sachs also noted in a report last autumn, other challenges in China are worse than 1990s Japan. “The urban residential property vacancy rate is around 20 per cent in China,” it notes, “more than double the 9 per cent rate that Japan endured in 1990, and housing prices are more stretched at 20 times household income in China, versus 11 times in Japan in 1990”.
Citibank echoes this: a recent client note warns that “while asset price corrections and its amplification shock via the banking system will likely be milder in China than Japan . . . China’s future growth prospects may be decelerating more sharply”.
So will Beijing actually act? Right now, the most realistic answer is “perhaps.” Deleveraging of the property sector has already started. Some bad loans are being securitised and traded. And property values are correcting: newbuild properties prices were down 2 per cent in annualised terms last year, compared to 10 per cent price growth late last decade.
Moreover, this week’s ruling by a Hong Kong court that calls for Evergrande, with its $330bn liabilities, to be liquidated could accelerate fire sales. It might also create more pressure for Beijing to embrace the policies that are needed to start a healing process, such as proper transparency around bad loans, legal mechanisms to swiftly trade (and price) impaired assets and economic measures to protect consumers from the worst pain.
But, sadly, uncertainty abounds too. It is unclear whether mainland Chinese courts will respect the Hong Kong liquidation ruling and whether other property groups will be allowed to collapse. It is also uncertain whether President Xi Jinping’s priority is to boost economic growth or uphold an ideological agenda that supports the Communist party’s rule. The former priority would call for transparency and legal certainty for investors; the latter for (more) delay in crystallising the pain.
Either way, as the world waits to see Beijing’s response to that Hong Kong ruling on Evergrande, there is another lesson to ponder from 1990s Japan: when investors have a gnawing anxiety that there are unresolved losses in the financial system they cannot quantify, this creates a stealthy, self-reinforcing deflationary mindset. And once a deflationary mood takes hold, it becomes even harder to tackle bad loans (since they expand relative to nominal gross domestic product).
Or to use the tagline that some Japanese used to recite to me: “You can put rotten meat in a freezer, but it doesn’t remove the rot. It just takes away the smell — for a while.” Someone should translate that into Chinese, and urge Beijing’s policymakers to show the world that they can do a better job in tackling the challenges than the Japanese and Americans initially did with their own financial rot. Evergrande could be a powerful test of that.