- “Goldman Sachs has suggested that investors look to Japan’s ‘lost decade’ as a guide to the future of the Chinese stockmarket.” – The Economist (Jan 11, 2025
After two decades of rapid expansion, China’s economy has seized up. Real growth has slowed dramatically, as reported by the World Bank and by the Rhodium Group (as opposed to Beijing’s official numbers, which are widely discounted). In current dollars, growth seems to have been negative from 2021-2023.
The ‘Japanification’ Scenario
This stall-out has drawn comparisons with the wrenching economic slowdown in Japan that began in the 1990’s with the collapse of the Japanese real estate market, and led to decades-long stagnation. Japan’s real Gross Domestic Product (GDP) per capita, which had grown at a rate of more than 5% annually from 1960 until 1990, slowed to just 0.9% annually from 1990 to 2007, and sagged even further thereafter.
The most striking sign of this economic malaise was persistent ultra-low inflation, tipping into actual deflation in 13 out of the following 28 years.
What has become known as Japanification includes a basket full of socio-economic deplorables.
- high savings rates, with correspondingly weak consumer spending
- near-zero or even below-zero interest rates
- soaring levels of public debt, partly driven by…
- …overinvestment in infrastructure and industrial capacity in an attempt to provide a fiscal stimulus
- rising unemployment, especially among younger workers (more than doubling between 1991 and 2002)
- a demographic decline due to an aging population and fertility rates well below the replacement level, and
- declining asset prices, with stagnant equities markets and a collapse of real estate values
- the proliferation of “zombie companies” burdened by debt, drawing off resources into unproductive investments
- overall, a “balance sheet recession” in which “companies focus on repaying debt to repair their balance sheets instead of borrowing to finance new spending and investment” and “everyone from companies to individuals concentrates on paying down debt at the same time, sending economic growth into a downward spiral.”
This ugly constellation of interlocking challenges proved highly resistant to the government’s stimulus measures. Investors more or less gave up on any recovery. The Japanese stock market did not return to its 1989 peak for nearly 35 years.
The Japanese real estate market never recovered.
Japanification has been a tragedy for Japan, derailing the Japanese post-war growth miracle. From 1960 to 1990, the Japanese economy was growing three times faster than the American economy (albeit starting from a much smaller base).
With the onset of Japanification, Japan fell behind. From 1991 until 2019, the Japanese economy grew at only ¼ the rate of the U.S. economy.
In sum, Japan fell off the economic fast track, and has never really recovered. The effects of Japanification are felt to this day.
The Chinese Parallel
There is a growing pessimism among China-watchers in the West (and apparently among many inside China) that China may be slipping into a similar scenario.
Chinese financial markets are flashing danger signs. The stock market is down 25% in the last four years. The government has pushed questionable countermeasures, ordering banks and insurance companies to buy shares to try to prop up the stock markets. It has not worked.
Chinese real estate values are falling fast.
Beijing is leaning on China’s state-owned banks to support the real estate market by buying up unsold houses. This is not working either.
Real estate price declines in China track the Japanese experience almost perfectly (96% correlation).
Chinese interest rates have fallen. Bond yields have fallen to an all-time low, which means that bond prices are soaring – a vast flight to safety is underway.
Investors are running away from “risk” in the Chinese markets. The authorities there are clearly worried about the Japanification analogy, and “have told analysts and economists working at banks to avoid… comparisons with Japan’s stagnation.”
Other similarities with the Japanese experience abound. Youth unemployment in China has soared. Fertility has fallen. Deflation is taking hold. Producer prices have declined for 27 straight months.
The case for the Japanification scenario looks strong. But China faces another problem, which may be more serious than the Japanification analogy implies.
A Crucial Difference
In Japan in the 1990’s, stocks prices fell and bond prices soared. But something else happened there, which isn’t happening in China.
As Japanese inflation fell and turned into outright deflation, the value of the Yen almost doubled. In 1990, the Yen traded at around ¥160 to the dollar. Five years later, the Yen reached ¥84 to $1. The correlation of deflation with the strengthening of the Yen from 1990 to 1995 was 87%.
Over 5 decades (1971-2024), this relationship held up. Inflation drove devaluation. Deflation, on the other hand, increased the Yen’s value.
Over the last four years (2020-2024) as Japanese inflation finally picked up significantly, and the correlation with the falling value of the Yen reached 91% – that is, recent Japanese inflation is almost perfectly correlated with devaluation of the currency.
This makes sense. Inflation reduces the purchasing power of the currency. If a $ or ¥ buys less than before, its value should logically decline.
Deflation should have the reverse effect, increasing the value of the currency. A deflating currency buys more today than it did yesterday. If the price of a dozen eggs was $4 yesterday, and it is $3 today – each dollar is “worth more” in the marketplace.
A Digression: Roosevelt’s Devaluation Experiment
Thus, normally, deflation and devaluation are opposing forces. In fact, currency devaluation has been used as a deliberate policy to counteract deflation.
In the United States, in the 1930s, in the depths of the Great Depression, Franklin Roosevelt intentionally, unilaterally, and audaciously devalued the U.S dollar by raising price of gold by 70% over a very short period.
- “The Roosevelt administration’s gold policy involved the deliberate devaluation of the dollar. The government did this by buying gold at increasing prices. These purchases raised gold’s value in terms of dollars, conversely lowering the dollar’s value in terms of gold and in terms of foreign currencies, whose value in gold remained pegged at old prices.”
This controversial policy was subject to much criticism and many challenges – and was only narrowly upheld by the Supreme Court. It was also highly effective.
Devaluation of the dollar was swift and substantial. In 7 months, the value of the dollar fell 40% in foreign exchange markets.
It was economic shock and awe. The dollar had had a fixed value in terms of gold – at $20.76 per ounce – for more than fifty years. FDR broke the connection almost overnight, raising the price of gold to $35 per ounce. His approach was ad hoc, and almost capricious.
- “[Roosevelt] would steer the gold price personally—from his bed, at breakfast time, while his advisers watched. One morning, FDR told his group he was thinking of raising the gold price by 21 cents. Why that figure, his entourage asked. ‘It’s a lucky number,’ Roosevelt said, ‘because it’s three times seven.’ As Henry Morgenthau later wrote, ‘If anybody knew how we really set the gold price through a combination of lucky numbers, etc., I think they would be frightened.’”
In total, it was a devaluation of the dollar larger than any of the formal devaluations of the Chinese currency in recent decades.
- “The goal was to raise American prices of commodities like wheat and cotton, returning them to the level of 1926, before the beginning of the contraction. This reflation would counteract the deflation that had dragged the economy into the abyss. The reflation would relieve debtors, resuscitate banks, and revive businesses. The reflation would lower prices of American goods abroad, encouraging exports, and raise prices of foreign goods in the US, discouraging imports.”
It worked. Deflation was brought to a halt, and commodity prices began to rise almost immediately. The “animal spirits” of the business community revived, the economy began to recover. U.S. GDP increased by 43% in the following four years. Unemployment fell from 25% 14%.
FDR’s gold program is often overlooked as a factor that helped lift the country out of the Depression. The academic consensus today is that “Roosevelt’s reflation accelerated America’s recovery.”
- “Perhaps the most persuasive research belongs to Barry Eichengreen and Jeffrey Sachs [who] demonstrated that economic recovery in the United States and in most of the world’s leading industrial nations began at the time they suspended the gold standard and reflated their economies.”
This classic study overturned the idea that the competitive devaluations by the major economic powers in the 1930s were detrimental.
- “Currency depreciation was beneficial… Similar policies, had they been even more widely adopted, would have hastened recovery from the Great Depression.”
Logically and empirically, deflation and devaluation should move in opposite directions. Currency devaluation – whether imposed by the market or as a matter of deliberate monetary policy – should be inflationary. A deflationary trend should cause the currency to appreciate. This relationship was clear in the U.S. in the 1930s, and has been clear in Japan in the last three decades.
The Chinese Anomaly
So what does this have to do with the Japanification of China?
China is clearly now entrenched in a deflationary state. Consumer price inflation is near zero, and the producer prices are in deep deflation.
But the Chinese currency is not appreciating, as it should, as the Japanese example would predict. Instead, the Yuan is rapidly losing value. It is now weaker than it has been in at least 15 years.
Since Dec 2021, as inflation has declined, so has the value of the Yuan. The decline of the Chinese Producer Price Index is 89% correlated with the Yuan’s loss of value.
Japanification 2.0?
So China is suffering from deflation and devaluation at the same time. This is an important difference from Japan’s experience
What does it mean? I’m not sure, but I don’t think it can be good.
It likely points to heightened instability in China’s economic situation.
The dynamics of any economy can be seen as battle between the forces that tend to create an equilibrium, and the forces that tend to lead to disequilibrium. The anomalous co-existence of deflation and devaluation in China today feels like a force for disequilibrium.
This hamstrings Chinese monetary policy, in two ways. First, any fiscal or monetary stimulus to designed to fight deflation runs the risk of further weakening the currency, which could exacerbate capital flight, suppress foreign investment, and threaten the stability of the financial system (as described in the previous column). Second, it eliminates the option of using the “Roosevelt maneuver.” Beijing cannot fight deflation with devaluation.
The persistence of deflation impairs the functioning of the credit markets, which eventually chokes off the lifeline for Chinese companies that have over-extended themselves.
- “The two Ds are a toxic combination. By increasing the real (inflation-adjusted) value of existing debt, deflation makes it harder for firms to secure additional financing, thereby raising the prospect of bankruptcies – a trend that is already discernible in China.”
It’s hard to see a way out of this trap. This “toxic combination” of deflation and devaluation represents an escalation of the stagnation scenario which Japan did not face. It signals a higher level of risk for China. The Japanese economy struggled with stagnation, but it was never really on the edge of tipping over into economic or political disorder. Japan was able to muddle through without coming apart, and the strength of its currency was a reflection of its fundamental stability. The weakness in China’s currency, even as deflation takes hold, is an ominous sign of socio-economic fragility that may transcend the “standard” Japanification scenario.
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