China As Japan 1985 Redux, Or Not

The IMF’s latest World Economic Outlook left its projections for China’s GDP growth for this year and next unchanged at 9.6% and 9.5% respectively, a slight slowdown from the 9.8% by which, the IMF estimates, the economy grew in 2010 and ahead of Beijing’s own forecasts. A set of traffic light warnings on whether the economy is overheating are mostly at amber.

The Outlook also devotes a sidebar to the lessons of Japan’s bubble in the 1980s and the effects of the rapid appreciation of the yen, forced on Tokyo by the Plaza Accord of 1985. The piece starts by saying that “some argue that this is a cautionary tale, exemplifying the dangers of reorienting economies through currency appreciation” and sourcing the some to the People’s Daily, so it is pretty clear where the lesson is directed. Not that that is any surprise given that the IMF has long been a critic of China’s slow appreciation of the yuan, a process being tightly managed by Beijing because of the risk of social dislocation.

The IMF authors’ central argument is pretty clear: the rapid appreciation of the yen wasn’t the cause of the Japan’s “lost decades”. The sequence of events is unquestioned. The yen’s rapid appreciation stopped Japan’s export and GDP growth in its tracks; the government responded with a big stimulus package; an asset bubble was inflated that went pop in 1990 and the economy has essentially been becalmed since.

What is put at question is whether the stimulus was excessive (yes, say the IMF’s authors) and whether it alone was responsible for the bubble (no, they say; financial deregulation allowing a rapid expansion of bank credit for real estate investment and tardiness in reining it in were also to blame; two factors compounded first by the overleveraging of Japan’s banks that were at the heart of keiretsu, or groups of closely affiliated companies, and then by the political constraints on authorities forcing the keiretsu to restructure and write off their debts which didn’t happen for a decade, allowing time for further policy missteps and external shocks). In short,

The conditions facing Japan were in many ways unique, and the bad post-Plaza outcome was due largely to a credit bubble that developed after exceptional policy stimulus was combined with financial sector deregulation. When the bubble burst, exposing underlying vulnerabilities, political economy constraints meant that restructuring progressed too slowly.

The IMF says circumstances in China today are different from those in Japan in the 1980s so past won’t be prologue. First, China’s households, corporations, and government aren’t as overborrowed as were Japan’s pre-bubble. Second, China has more room to move up the export quality ladder than Japan did, which will help offset the impact on growth of currency appreciation (though risks labor dislocation in low-end export manufacturing), and third, Japan had a floating exchange rate regime in the 1980s, whereas China has a managed exchange rate supported by vast foreign currency reserves and restrictions on capital inflows. “This difference in currency regimes should help China avoid the sharp appreciation observed in Japan,” says the IMF. Which is exactly Beijing’s point.