During her recent visit to Beijing, International Monetary Fund head Kristalina Georgieva connected the dots between China and Japan in ways that Xi Jinping\u2019s inner circle probably didn\u2019t appreciate.<\/p>\n
While urging President Xi to make the \u201cbrave choice<\/a>\u201d of accelerating structural reforms to transition China to a consumption-led model that relies less on exports, Georgieva highlighted the need to end the property crisis that\u2019s fueling deflation.<\/p>\n \u201cChina is simply too big to generate much (more) growth from exports, and continuing to depend on export-led growth risks furthering global trade tensions,\u201d Georgieva told reporters about the US$19 trillion economy. \u201cIt requires brave choices and determined policy action.\u201d<\/p>\n Then, she pivoted to the \u201cJapanification<\/a>\u201d risk of it all, urging Beijing to let unviable property developers fail, if needed. \u201cWe have been urging more attention for closure on this problem,\u201d Georgieva explained. \u201cWe call them \u2018zombie firms.\u2019 Let the zombies go away.\u201d<\/p>\n To be sure, comparisons between Japan and China are hardly ideal. For one thing, Japan\u2019s deflation troubles were many years in the making and stemmed from a titanically larger pile of bad loans hobbling the banking system and policymaking malpractice across several governments. China\u2019s property reckoning is more of a post-Covid-crisis phenomenon.<\/p>\n Yet as Japan has taught the world, the longer debt overhangs are allowed to fester, the more entrenched deflation becomes. China\u2019s falling-price troubles are about to enter a fourth year.<\/p>\n The problem, however, is that China faces a lost-in-translation issue. It\u2019s entirely possible that Xi and Premier Li Qiang are acting boldly behind the scenes to stabilize China\u2019s property sector<\/a>. Yet pledges by Xi and Li are no longer enough. Chinese households and global investors alike are increasingly concerned that Beijing is overconfident in its ability to avoid a Japan-like lost decade.<\/p>\n Changing this perception is key to ending deflation. One of Team Xi\u2019s top pledges, for example, has been to prod households to deploy the US$22 trillion of savings they\u2019re sitting on. This, however, requires building a robust, sizable social safety net to encourage consumers to spend more and save less.<\/p>\n It also requires reviving the property sector. With roughly 70% of Chinese household wealth wrapped up in real estate, stopping the financial bleeding is vital to increase spending so that Beijing can maintain 5% economic growth<\/a>.<\/p>\n Barring bold and credible plans to put a floor under real estate and give 1.4 billion Chinese reasons for economic optimism, deflation could continue to fester.<\/p>\n It\u2019s a complicated issue, of course. Not all deflation is bad. In Japan, households came to regard sliding prices as a stealth tax cut. These days, of course, Tokyo faces the flipside of the problem as inflation rises at roughly 3%.<\/p>\n This makes the Bank of Japan the economic equivalent of the dog that caught the car. Many consumers are actually missing deflation as stagflation erodes living standards.<\/p>\n In China\u2019s case<\/a>, many economists have argued that weak prices could benefit technology companies looking to expand, high-dividend stocks and exporters with diversified businesses.<\/p>\n Still, the overcapacity that China is exporting is irking trading partners \u2014 particularly the tariff-wielding US. And the excessive price competition that Xi is struggling to stamp out \u2014 so-called \u201canti-involution\u201d \u2014 is taking on a life of its own.<\/p>\n It\u2019s high time Xi\u2019s economic team got a handle on deflation once and for all. And to head off the nation\u2019s nascent zombie problem as soon as possible.<\/p>\n In a\u00a0new study<\/a>\u00a0by the Federal Reserve Bank of Dallas, economists Scott Davis and Brendan Kelly argue that \u201cthere\u2019s mounting evidence of \u2018zombie lending\u2019 in China, banks rolling over bad loans to unprofitable firms and allowing the status quo to continue rather than recognize losses.\u201d<\/p>\n In many ways, they assert, \u201cthe current experience in China mirrors that of Japan in the 1980s and 1990s<\/a>. Rapid growth in private sector debt\u2014also fueled by domestic savings\u2014was followed by the appearance of zombie lending. In Japan, that zombie lending led to the inefficient allocation of capital and decreased productivity, especially in sectors shielded from foreign competition.\u201d<\/p>\n Chinese authorities, the economists point out, have announced a high-profile anti-involution campaign in 10 leading manufacturing sectors. Its success will be important in limiting the share of zombie assets in the manufacturing sector.<\/p>\n Yet, the Dallas Fed warns, \u201cthe higher zombie share in services may be equally important at a time when authorities pursue tentative efforts to rebalance the economy in favor of\u00a0consumption<\/a>\u00a0and services. While policies include some direct support to households, a key focus appears to be boosting investment in services, including through\u00a0subsidized loans<\/a>.\u201c<\/p>\n Sonali Jain-Chandra, a top IMF China economist, argues that the key is to accelerate \u201creforms to rebalance demand toward consumption and further open the service sector, which can promote sustainable growth and help create jobs.\u201d<\/p>\n While \u201cChina\u2019s economic development over the last several decades has been remarkable,\u201d it \u201chas relied too much on investment as opposed to consumption,\u201d Jain-Chandra says.<\/p>\n Slowing productivity and an aging population risk limiting growth, which we expect to slow significantly in coming years. A comprehensive and balanced policy approach is needed to address these challenges. Given these circumstances, Jain-Chandra says, China\u2019s service sector is an \u201cunderexploited driver of growth\u201d needed to revive economic confidence.<\/p>\n There\u2019s an argument, too, that the People\u2019s Bank of China<\/a> must act more assertively to add liquidity to the economy. In November, the level of credit expansion in Asia\u2019s biggest economy remained subdued. Financial institutions issued just 392 billion yuan (US$55.7 billion) in new loans, well below expectations for a 450 billion yuan (US$64 billion) increase.<\/p>\n Last month, household loans contracted for the second consecutive month. It was the first time that happened since Beijing began keeping records in 2005. Corporate borrowing remains lackluster, too. Fixed-asset investment is on track for its first annual decline since at least 1998.<\/p>\n \u201cWe expect credit growth to remain weak over the coming months,\u201d says economist Leah Fahy at Capital Economics.<\/p>\n Earlier this week, the PBOC signaled it would maintain its supportive monetary policy stance, but not much more. In many ways, the PBOC is limited by political considerations \u2014 including fears a weaker yuan might exacerbate trade tensions with Washington.<\/p>\n Also, Xi has long sought to reduce leverage in the financial sector and, at least in theory, provide less aid and comfort to corporate zombies. Yet in the year ahead, odds are high that the PBOC will become more active in battling deflation<\/a>.<\/p>\n The effort must be accompanied by Team Xi cleansing developers\u2019 balance sheets.<\/p>\n