Will asset bubble go the Japan way?
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A valuable lesson learned from Japan is that imbalances cannot be corrected through macroeconomic measures alone. They have to be accompanied by microeconomic reforms. The fact that microeconomic reforms are being implemented in China for some time now gives the country a chance to avoid a Japan-style downturn.
Success depends on reallocation of resources to revitalize China's heartland. The game plan to rebalance the economy away from investment toward private consumption is important. As part of the urbanization policy, the vision is to develop key cities to function as regional growth engines. Among them are Tianjin (in the north), and Chengdu and Chongqing (in the west).
Plus, more funds will be allocated to education, healthcare and public housing, especially to help bridge the rural-urban divide and achieve the specific goal of quadrupling per capita income by the year 2020.
But China has to beware of the pitfalls. China's vulnerability could be heightened by a combination of unfavorable factors. Hypothetically speaking they include lower global demand, policy mistakes on the speed and sequence of reform, and failure to see through reform implementation at the micro-level.
Slower global growth could prompt Chinese firms to invest less and consumers to cut their spending. An economic slowdown, because of low global demand and continued tightening policies, may be relatively mild at first but could increase non-performing loans as firms' revenue drop and financing costs rise. There is a risk of a pull-back in lending activities if banks are under pressure to meet the capital adequacy requirement of 8 percent. If credit lines are pulled, it could potentially aggravate the correction in the asset and real estate markets.
The asset market, especially the stock market, will not be immune to correction as investors grow more sophisticated and pay more attention to valuation. The correction in the asset market could be triggered by an outflow of domestic savings for overseas investment (if and when the door is opened wider). This is why the Chinese authorities have proceeded very cautiously in liberalizing the capital account. They still need the large domestic savings pool to fund domestic investments, recapitalize banks and plug the unfunded pension liabilities gap.
A sharp correction in the asset market will not necessarily lead to a prolonged and deep economic recession as it did in Japan. The Chinese have been more proactive than their Japanese counterparts in implementing corporate and banking sector reform, although the process is far from over. Their cautious and gradual reform approach seems appropriate because, on average, risk management capacities are not yet fast enough. Overall, China's attractive long-term potential and its large market size still make a compelling case for investors.
The author is a senior economist at Deustche Bank.
