China is facing the triple challenge of mounting debt, an aging workforce and deflation, prompting many observers to question whether the world’s second-largest economy could be facing a fate similar to Japan’s in the 1990s. During this period, economic stagnation and price deflation transformed Japan’s bustling economy of the 1980s into an economy that grew at a little more than 1% annually over a decade.
Fortunately, China can ward off this scenario—but policymakers will need to act quickly and decisively.
Avoiding the Spiral
China does have some macroeconomic similarities to Japan in the 1990s. First, its debt has risen sharply, from 270% of GDP in the last quarter of 2019 to 300% of GDP as of the first quarter of 2023. Second, long-term demographic trends have been crimping the labor force and thereby potential economic growth, as nearly one-third of the population will be over the age of 60 by 2035. Finally, deflationary pressures are widespread in the economy, exacerbated by attempts to reduce debt in both the property sector and local governments, which together account for about 70% of GDP.
But while there is a risk that China could fall into a similar debt-deflation spiral—in which persistent deflation takes hold, the debt-to-GDP ratio keeps rising and GDP per capita stagnates—the country appears to be better positioned today than Japan was during its economic decline, for four reasons:
Asset prices in China have not run up as much as they did in Japan during its 1980s boom.
Although per-capita income in China has increased significantly over the last few decades, it’s still low relative to most developed nations, implying there is room for catch-up growth in productivity.
Unlike Japan, China’s currency has not appreciated significantly, with less impact on its competitiveness.
China’s real interest rates are below its real GDP growth, whereas Bank of Japan kept real interest rates higher than real GDP growth between 1991 and 1995.
This last point is perhaps the most crucial. Historically, when economies are seeking to stabilize or reduce debt, the key element is to ensure that there is an adequate gap between real interest rates and real GDP growth.
In Japan's case, real interest rates were higher than real GDP growth for the first four years of the 1990s. A similar situation occurred in the U.S. after the 1929 stock market crash. As the government kept real rates high, it laid the ground for the beginnings of the Great Depression. U.S. policy easing sparked a recovery starting in 1933, but then a premature tightening in 1936 caused a double dip in 1937.
With the benefit of hindsight, it’s clear that keeping real interest rates below real growth via sustaining expansionary monetary and fiscal policies is key to reducing debt. Why? Simply put, it’s impossible to pay down debt if the interest rate on that debt is growing faster than the increase in income.
For now, China’s growth has exceeded interest rates by over 2 percentage points—a favorable starting point. But in the last three months, growth fell significantly—suggesting that China’s policymakers will need to act forcefully to prevent a debt-deflation loop from taking hold.