Michael Pettis: How China Can Avoid the Japan Trap (WSJ 2010.10.29)

A very insightful piece from Michael Pettis, professor of finance at Peking University and a senior associate at the Carnegie Endowment for International Peace.

World leaders don't agree on much economic policy these days, but one thing that does set heads nodding is the idea that China needs to rebalance its economy toward greater domestic consumption. The only question is how. Beijing clearly worries that making the transition too quickly could prove economically disruptive and politically destabilizing.

But China is not the first country to have attempted─willingly or otherwise─such a transition. Leaders in Beijing can look across the sea to Japan in particular for a case study in what to do, and what not to do, during such a transition.

Japan became an export powerhouse in the 1980s and '90s following a strategy very similar to what China does today: Policy makers discouraged household consumption by suppressing wages and holding interest rates on savings deposits artificially low. Meanwhile, they encouraged investment through cheap lending rates and subsidies on many inputs used by manufacturers, including socializing credit risk.

One consequence of this strategy is that households effectively subsidize manufacturers through the lower interest rate on savings that allows borrowers to pay lower rates, too. When Japan was still in an expansionary phase, and in China today, that amounts to hidden debt forgiveness because artificially low interest rates mean the present value of future payments can be less than the amount of money borrowed. Under these conditions, it makes sense to borrow even if the proceeds are invested in projects with low or even negative net present values.

In China now, the result also looks very similar to Japan then: a trade surplus the world increasingly is unable to absorb, and massively misallocated investment. This model also distorts the allocation of the proceeds of growth. During the last two decades of Japan's economic miracle, household income─and with it consumption─grew more slowly than overall GDP.

These similarities to Japan might cause unease among Chinese policy makers. But China can make the transition to domestic consumption more successfully by learning some Japanese lessons.

The first is related to debt. A major contributor to Japan's staggering debt level─approaching 200% of GDP in gross terms─has been efforts to transition to greater domestic demand with as little disruption as possible. Tokyo has used government money to clean up banks that had made uneconomic loans under the earlier industrial policy. It has also funded massive public-works spending in an effort to boost domestic demand. None of that spending has been very effective. Little of the money has filtered down to the consumer level.

Meanwhile, the amount of debt creates its own policy trap. Especially since so much of the debt is held domestically by Japanese savers, the same interest-rate subsidies households once were forced to offer to exporting companies now accrue to the government. This at least means Japan's debt may not be as burdensome as sometimes imagined─if interest rates are only half of what they should be, for instance, that would mean the true debt burden after factoring in implicit debt forgiveness is only half the nominal burden, or about 100% of GDP. That's high but manageable. Under conditions of deflation it is true that real rates are higher, but with nominal rates close to zero Japan can ignore the real debt burden as long as it can keep rolling over principal.

The problem is that the debt is only manageable as long as interest rates are kept low. If they rise to anywhere near a level that represents the true economic cost of capital, Japan's real debt burden will quickly rise to its nominal level. Yet continuing to suppress interest rates at the expense of households only slows the transition to consumption-led growth that Japan so badly needs. In effect, policy makers in Tokyo are forced to choose between hastening a growth-inducing rebalancing or servicing existing debt.

One lesson for Beijing is to avoid that trap. It may sound easy since national government debt as a percentage of GDP is only 20%. But factor in local-government and other contingent debt and the total percentage rises to well over 60%. And this is before the transition to domestic consumption has started in earnest. China must be careful to avoid Japan's practice of muting the effects of restructuring through unsustainable government spending.

The thought of allowing rebalancing to unfold without extending government aid to 'keep the peace' may sound scary to policy makers in Beijing keen to avoid any social disharmony. But here at least Japan offers a ray of hope to China: The rebalancing need not be as politically destabilizing as it sounds.

For 20 years one of the most puzzling questions for analysts was how the Japanese public accepted with such equanimity the collapse in growth after 1990. The answer is that some rebalancing was happening, albeit not fast enough.

Per-capita GDP stagnated. But consumption per capita tells a very different story. Adjusted for deflation and population shrinkage, real per-capita household consumption has grown only a little more slowly after 1990 than it did before 1990. The collapse in Japanese GDP growth did not come with a collapse in Japanese consumption growth because as the economy rebalanced, no matter how painfully, at least some wealth was transferred from the state and companies back to the household sector.

Social welfare transfers, higher real interest rates as a consequence of deflation, and a strengthening currency, helped transfer income from the government, from exporters, and from capital-intensive companies, to Japanese households. Most of the slowdown, in other words, was borne by businesses and governments.

These Japanese lessons suggest China doesn't need to fear rebalancing, as long as policy makers handle the process correctly. The key is to allow the transition to happen instead of trying to thwart it for fear of discontent that might well prove less scary than it sounds.

(Mr. Pettis is a professor of finance at Peking University and a senior associate at the Carnegie Endowment. )