The Decisive Actions Needed to Avoid a Lost Decade

Although China’s economy faces challenges in terms of debt, demographics and deflation, the right policy approach could ward off a debt deflation loop.

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Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist. Along with my colleagues, bringing you a variety of perspectives, today I'll be discussing the journey ahead for China as it faces the triple challenge of debt, demographics and deflation. It's Thursday, August 17, at 9 a.m. in Hong Kong. 

Before we get into China, I want to take you back to the oft-told tale from the 1990s when Japan experienced what we now refer to as the ‘Lost Decade.’ During this period, the combination of economic stagnation and price deflation transformed a bustling economy in the 1980s, into an economy that grew at a little more than 1% annually over a decade. 

Fast forward to today, where China is confronted with the triple challenge of debt, demographics and deflation, what we are calling the 3Ds. As a result, many investors are now concerned that China will be stuck in a debt deflation loop, just like Japan was in the 1990s. 

But is China better placed to manage these headwinds even though the risks of falling into debt deflation loop remain high? We think at the starting point, the answer is yes, but with a few historical lessons that I'll get into in a moment. 

For context, China compares better with the Japan of the 1990s in the following four aspects. First, asset prices in China have not run up as much. Second, per capita incomes are still lower in China, implying a higher potential growth runway. Third, unlike Japan, China has not experienced a big currency appreciation shock. 

And finally, perhaps the most crucial difference is policy setting. Back in the 90s, the Bank of Japan kept real interest rates higher than real GDP growth between 1991 and 1995. But in contrast to Japan, China's real rates are below real GDP growth currently. 

To explain, historically, when economies are seeking to stabilize or reduce debt, the key element is to ensure that there is adequate gap between real interest rates and real GDP growth. In Japan's case, real interest rates were maintained about real GDP growth for the first four years. A similar situation occurred in the US post the 1929 stock market crash. As real rates were kept high, it laid the ground for the beginnings of the Great Depression. 

From both of these examples, the historical track shows two policy missteps. First, policymakers' concern about reigniting misallocation leads them to gravitate towards a hawkish bias. Second, policymakers tend to turn hawkish too quickly at the first signs of a recovery. During the Great Depression, easing of policies had led to recovery from 1933 onwards, but a premature tightening of policies in 1936 led to the double dip in 1937/38. Contrast this with the US after 2008, when the Fed was quick to bring rates to zero and embark on successive rounds of quantitative easing while fiscal policy was deployed in tandem. 

Sustaining real interest rates 2 percentage points below real GDP growth is key to deleveraging. Why? Because if you think about it, deleveraging will not be possible if the interest rate on your debt is growing faster than the increase in your income. 

In this context, while China's real interest rates are below real GDP growth currently, we still see the risk that policymakers will not take up reflationary policies to sustain the rates minus growth gap, which keeps the risk of China falling into debt deflation loop alive. 

So what is the potential outcome? China's policymakers will need to act forcefully. If they don't, the economy could fall into debt deflation loop, persistent deflation would take hold, debt to GDP would keep rising, and GDP per capita in USD terms would stagnate, just as it happened in Japan in the 1990s. But, as history has shown us, that doesn't have to be the outcome. 

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