Op-Ed Contributors

Is China repeating Japan's mistakes?

By Takatoshi Ito (China Daily)
Updated: 2010-04-20 07:52

Editor's note: The sharp increase in property prices in China is fostering a bubble and there are many similarities and common factors between current China and Japan in the late 1980s. Is China repeating Japan's mistakes?

The recent inflationary increase in property prices is the greatest risk that China faces today. Anecdotal evidence indicates that price increases have reached 50 percent or more in cities like Shanghai and Shenzhen.

It is difficult to assess the magnitude of the risk, since reliable data that are controlled for location and quality are hard to obtain. It is possible that property price increases are justified by fundamentals, or by "real demand" for owner-occupied housing.

However, it is more likely that the very high prices are caused by speculative investment. Demand has been created by expectation that the prices will continue to rise rapidly, so that investors can pocket profits from selling in the near future. Such speculative demand results in actual price increases, confirming expectation.

This process is known as a bubble. A bubble eventually collapses, resulting in losses for speculators, developers, and banks who lend to them.

The Japanese economy went through one of the largest property bubbles in history in the last quarter century.

Sharp increases in property prices for five years in the second half of the 1980s were followed by steady declines for fifteen years. The land price index tripled in five years. The price index for residential land in six large cities rose from 39.2 in September 1985 to 105.8 in September 1990. The commercial land price index rose from 27.9 to 104.5. Land prices first rose in the central part of Tokyo, then spread to first-tier suburbs, then to smaller cities and second-tier suburbs, and finally to rural areas. They were fueled by the easing of monetary policies and optimistic expectations of the future of the economy.

When property prices, along with stock prices, started to fall in 1990, the speculative process reversed. The painful, long stagnation of the economy was marred by a series of banking crises that were mostly caused by mishandling of non-performing loans to the real estate sector.

How similar is China today to Japan in 1989? There are many similarities and common factors.

First, property prices are out of reach for ordinary wage earners. Real demand has declined. The prices keep rising because speculative money continues to pour into the market. Also, real estate development has pushed into far-away suburbs where prices are still affordable. The spread of price increases to suburbs and local cities is a sign of overheating in prime areas.

Second, monetary policy has encouraged such speculation. The interest rate was kept low in Japan in the late 1980s, because the authorities wanted to curb appreciation of the yen. The interest rate has been kept low in China since the collapse of Lehman Brothers in an attempt to stimulate domestic demand. Ample liquidity and encouragement from the monetary authorities to expand bank credit contribute to enlargement of a bubble.

Third, a lack of alternative domestic investment opportunities and various restrictions on foreign investment in private sectors have channeled funds into the real estate sector.

Fourth, the land supply is limited. In Japan, various tax measures and land use restrictions limited large-scale development. In China, land is owned by the State, and the authorities can control how many properties are sold. The authorities may have an incentive to keep the prices high.

Of course, there are differences too. Overall growth opportunities in China today seem much greater than they were in Japan in the late 1980s. China still has low-income rural areas where capital and labor have not been fully mobilized for economic growth. High economic growth may continue for another 20 years. The People's Bank of China has recently tightened regulations on the loan-to-value ratio and reserve requirements on banks in an attempt to curb bank lending. However, on balance, similarities outweigh differences.

Will the bubble burst soon in China? And will this lead to a collapse of the economy and a repeat of the sorry performance of the Japanese economy in the 1990s?

Given the rate at which property prices have increased in China, a slowdown seems inevitable. Speculators who count on high returns will not be satisfied with limited price increases and will start to unload inventories. That will turn the market from bull to bear. Eventually, speculators will not be able to find buyers, and - based on what happened in Japan - prices will decline.

The big question is what happens next. The best policy is for banks to write off losses early and replenish their capital. Chinese banks now have strong reserves and growth potential, but so did Japanese banks in 1989.

The important thing is to be transparent and to force banks to take action early. If non-performing loans are hidden and losses are not dealt with, then the problem becomes larger and before long it overwhelms the banks' capital buffer. Japan's mistake should not be repeated.

The best way to deal with a bubble is to prevent it from bursting, rather than trying to contain the damage once it does. The larger the bubble is, the more difficult it is to manage. The best way to prevent a bubble from becoming larger are to raise interest rates, tighten bank loans to real estate developers and second-home buyers, and require banks to increase capital as their credit expands.

However, raising interest rates will invite more short-term capital inflows. Therefore, interest rate hikes must be combined with floating of the RMB. One-time appreciation and flexibility are recognized ways to stop dangerous inflows of short-term capital.

If China resists appreciation of the RMB, the likelihood of repeating Japan's mistakes will become higher.

The author is a Professor from Graduate School of Economics of the University of Tokyo.

(China Daily 04/20/2010 page9)