China’s economic M*A*S*H-up points to more painful zombie spell than Japan’s

(Originally published Sept. 18 in “What in the World“) China may be headed into a Japan-style economic zombie state, in which debt repayments crowd out economic growth. So what? A lot of people remember Japan’s “lost decades” as a surprisingly comfortable period. But China’s suspended animation may be much more painful.

As The Wall Street Journal details, Japan went into its spell with a lot more going for it: it had managed to become far more prosperous than China is now. And Japan’s population, while declining, didn’t start doing so until 17 years into its undead terror, in 2008. Before that, Japan’s population was only aging. China’s population started declining in 2022—and almost 2% of the population, 28 million people, are due to retire this year.

Tokyo was also able to hurl massive amounts of government spending into the economy that, while failing to revive inflation or growth, did help numb the pain. Beijing has plenty of money to do the same, but it has a much bigger vacuum of provincial and metropolitan debt to fill if and when it does. Just keeping the public services now paid for by those local governments could swallow up much of any fiscal stimulus efforts by Beijing.

The other problem, of course, is that foreign investors don’t exactly relish the prospect of working in an undead economy. Foreign direct investment into China fell 5.1% in the first eight months of this year, to 847.17 billion yuan ($116 billion), according to the latest data from China’s Ministry of Commerce.

China’s banks face another interesting problem: with housing prices falling, more and more Chinese consumers are paying down debt rather than spend cash. While that’s been discussed in this space before, what hasn’t is that those debt repayments are torpedoing bank earnings, making them even more vulnerable to the property bubble plaguing developers, local governments, and households.

Here’s why: Chinese homeowners who can are paying off their mortgages early. That not only deprives the banks of the interest income on those mortgages but removes healthy assets from their balance sheet. What’s left is a higher proportion of risky loans to sketchy borrowers who are barely making their interest payments.

As the risks rise on their loan book, banks have no choice but to set aside more and more of their funds against possible defaults. And that means they have less cash to lend out. Of course, China’s slowing economy has reduced demand for new loans, and the People’s Bank of China has decreed that banks lower mortgage rates for loans on first-time home buyers to try to reverse that. But the increasing provisions banks will have to set aside reduces the amount they can use to refinance debts coming due for strapped borrowers. That increases the likelihood that those borrowers are unable to refinance their loans and are instead pushed into default.

Wary consumers, therefore, are essentially tightening credit to China’s economy, hastening the very crisis they and the government want to avoid. This is the kind of situation that prompts banks to throw good cash at refinancing bad loans, a.k.a. “extend and pretend.” That is to say, just extend the maturing loans or roll them over and pretend that the borrower will someday be able to repay you.