China is turning Japanese

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The “Japanification” of China continues to be a big theme, with a lot of eerie parallels right down to stimulus proving wanting. Here’s the latest symptom:

Yep, the 30-year government bond yields of China and Japan are on the cusp of crossing paths for the first time (ever, we think, but LSEG data for both 30-year benchmarks doesn’t go further back than 2009).

At pixel time there’s still a 10 basis point spread between the two long-term bond yields, with the Chinese 30-year yielding 2.245 and the Japanese 30s trading at 2.144 per cent. But it looks like that won’t last long. Shorting Chinese government bonds really has been the new widow-maker trade.

The fading yield curve differential is another stark manifestation of China’s growing economic and demographic malaise, and Japan’s (for now) success in finally winning a three-decade battle against deflation. The subject even got the full Martin Wolf treatment in the FT earlier this week:

Need China turn into Japan? No. Might it turn into Japan? Yes. Moreover, the longer it waits to tackle its ailments, the more likely it is to fall seriously ill, with slow growth and chronic deflationary pressure. Some outside analysts believe this is inevitable. But wanting to believe something does not make it true. China’s disease is not incurable. But it is serious.

The shift from the dominant narrative of the past 20-30 years — that China would inevitably catch up with and eventually eclipse the US as the world’s largest and most dynamic economy — couldn’t be starker.

The post-financial crisis era was particularly euphoric on China, as it kept proving the naysayers and short sellers wrong. In fact, it became by far the biggest contributor to global economic growth in the post-2008 era.

As we noted in a previous post, between the beginning of 2010 and the end of 2020, China’s gross domestic product grew by about $11.6tn in current-dollar terms. That’s roughly equivalent to adding almost four UKs or Indias, nearly three Germanys, more than two Japans, and an Indonesia every year for a decade.

Today, the narrative couldn’t be more different — it’s all about whether China can escape a Japanese-style multi-decade battle against deleveraging, deflation, adverse demographics and dismal growth rates.

Here’s what Barclays’ economists said in a big report on the topic last month:

China’s accelerated economic development was reminiscent of Japan’s postwar economic miracle. Moreover, China was in certain quarters once expected to overtake the US as the world’s largest economy by 2035.

However, after decades of rapidly narrowing the gap to the US, since 2022 China has started losing ground. Surpassing the US economy now appears a distant hope; its weakening labour market, declining firm profitability, slumping housing activity, and adverse debt-deflation dynamics have raised concerns about China’s longer-term growth outlook.

. . . We think China’s deleveraging journey has only just started, and it is unlikely to be completed before 2030, which implies the structural headwinds to consumption and investment will persist.

Indeed, as Goldman Sachs noted recently, China’s overall indebtedness is actually rising again, and will probably cross the 300 per cent of GDP mark this year (if it hasn’t already).

It should be noted that there’s still a decent-sized if narrowing gap between China and Japan on the 10-year part of the curve. But on the even longer end of the curve, yields have already crossed, with the Japanese government bond maturing in March 2064 currently yielding 2.472 per cent, and China’s November 2064 bond trading at 2.275 per cent.

The parallels between Japan in the early 1990s and China today are myriad, Barclays noted in its report. And in some economic respects, China is now looking more Japanese than Japan. FT Alphaville’s emphasis below:

The economic circumstances facing China have parallels with Japan’s experience after its asset bubble burst in the early 1990s. This created the term ‘Japanification’, which is typically defined as a combination of slow growth, low inflation, and a low policy rate, accompanied by deteriorating demographic trends.

To measure this phenomena, a Japanese economist, Takatoshi Ito, introduced a Japanification Index, which measured the sum of the inflation rate, nominal policy rate, and GDP gap. To apply to China’s economy, we have adjusted this index, replacing the GDP gap with working-age population growth, as the estimation methods of GDP gaps differ across nations and working-age population is by far the most fundamental determinant for long-term growth. Our amended index shows that China’s economy has become more ‘Japanised’ than Japan’s recently, albeit marginally.

This not a surprise to us. A demographic drag, the emergence and collapse of asset bubbles, debt overhang, zombie companies, deflationary pressures from excess capacity/high debt, and high youth unemployment, to name a few, are some of the notable similarities between the economies of China and Japan post their bubbles.

And here’s that index.

Beijing is obviously not oblivious to the dangers, and is unveiling a series of measures designed to restore some economic vim. As Martin Wolf pointed out, China still has a lot of advantages over Japan in the 1990s, not least that it can learn from what its neighbour did wrong.

But so far it seems to be making some of the same mistakes. Third-quarter GDP data will be published tomorrow, and economists expect it to have slowed to 4.5 per cent. The IMF’s own forecasts will come out next week. 🍿