Economist Richard Koo’s theories influenced Western policy decisions after the global financial crisis, and now he has strong words for Chinese policymakers on the need for fiscal stimulus to ward off a ‘balance-sheet recession’.
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What must China do to avoid a Japan-type recession? Economist Richard Koo adds up why ‘the Chinese situation is far more serious’
Richard Koo, chief economist at the Nomura Research Institute, has advised several Japanese prime ministers on economic issues. He is known for elaborating on the notion of a “balance-sheet recession” and explaining how it led to Japan’s so-called Great Recession. This interview first appeared in SCMP Plus. For our complete Open Questions series, click here.
Whereas a typical recession is considered to be a natural result of fluctuations in the business cycle, a balance-sheet recession is characterised by high levels of private-sector debt that lead to increased saving, which in turn results in an economic slowdown – because of reduced household consumption and declining business investment.
While much of the developed world is tackling elevated inflation,
China’s consumer prices have been rising by less that 1 per cent every month for more than a year as consumers save their money and as many businesses wait to see if the government will introduce major stimulus measures before expanding investment.
Ahead of any such moves, Koo spoke with reporter Frank Chen about the Chinese economy, troubles it faces, lessons that can be gleaned from Japan’s missteps, and how Beijing should formulate its response and policy mix.
Mr Koo, in the midst of economic uncertainties fuelled by high levels of indebtedness and a real estate crisis – two potential causes of what you deem a balance-sheet recession – what are the risks that China might be facing such a predicament?
I have been invited to speak on numerous occasions [in mainland China] and have participated in some policy debates. A lot of economists worry that China may slip into a balance-sheet recession, but there are also other views out there.
Even though China’s first-quarter GDP growth came out to
5.3 per cent, many people remain depressed, not knowing whether manufacturing-led growth [can be sustained] when trade tensions remain so high.
Some say [the economic problems are about] structural reforms, nothing to do with balance sheets. They argue that if we just do a little bit of monetary and fiscal stimulus, everything will be fine.
Those were the typical arguments we heard in Japan 30 years ago when [its troubles began]. The country constantly tried all types of structural-reform policies, but it took 20 years to come out of that mess.
The United States, on the other hand, had those [arguments] too during the onset [of the recession following the 2008 financial crisis], but within the first two years, [former Federal Reserve chair] Ben Bernanke read my book and realised that it was a balance-sheet recession. Once he realised it, he started pushing for fiscal stimulus [with the famous phrase “fiscal cliff”], which went against his original judgment that monetary policy alone could solve all these problems. So, the US came out of that [recession] relatively quickly.
Top European policymakers did not buy the balance-sheet recession theory at all. So, they kept on pushing for structural reforms and wasted years. Europe took almost twice as long as the US to come out of the same balance-sheet recession.
So, if you put the right policies in place, you come out of the recession relatively quickly. But if not, you could be stuck in there for a very long time.
So, your advice is that Chinese policymakers should look at how to reduce the risks of a balance-sheet recession and commit to acting on related measures now?
Yes.
On the size of the fiscal stimulus, I say when you’re going to make a mistake, make sure you make the mistake of having the stimulus be too big instead of too small. It has to be big, because a balance-sheet recession can kill the economy very quickly.
If [the stimulus] is too small and the economy starts weakening quickly – and only at that moment do you decide [to implement] a bigger one – the cost will be much larger than had you started with the right amount in the first place.
If you allow the Chinese economy to suffer a very bad affliction, and then you try to help it recover, the consequences could be dire, given its sheer size and the weight it carries globally.
The response I get from those sceptical about the balance-sheet recession in China is: we tried a big stimulus in 2008, and that created all sorts of problems a few years later, so we don’t want to repeat the same mistake. This seems to be the main consideration nowadays.
Here is my counterargument: when the Chinese government announced the 4 trillion yuan package [in November 2008] to maintain 8 per cent growth, economists around the world were laughing. They asked how China could maintain such growth with a great dependency on exports when the whole global economy was collapsing and Chinese stocks by then were already down 70 per cent from the peak.
But one year later, China recorded 11.9 per cent growth in Q1 2010, and nobody was laughing. That growth helped restore confidence in no small way, because people had thought that China would go down just like the US, Europe and Japan. And more confidence helped increase consumption and investments and got the economy moving again.
The 4 trillion yuan package, of course, was a bit too big down the road, with too much debt and overinvestment.
So, the lesson is that you put a big stimulus in first, to win back confidence that the government can maintain growth. And then, once you get the economy moving again, you start reducing your stimulus. [In the 2008 experience,] China recorded much higher growth the following year, so China should have started cutting the package.
I think this is also what we need today: a big package, and the package should be for a long term to assure people. When people feel confident, some may actually increase consumption and investment, then we get out of this thing faster.
So, you put in a very assuring package, let’s say for five years. And if, in the second year, the economy is already recovering, you start trimming it so that the economy won’t become overheated.
So, you are now calling for the kind of decisiveness and resolve demonstrated by China in 2008? And if there is a stimulus today, how big should it be?
Given that the Chinese economy is so much bigger now, you would need more than 4 trillion yuan (US$552 billion). For the announcement part, I would recommend a very big package, and you need to explain to people why we need it now.
If I were the finance minister, I’d be on television explaining this: look, the private sector is in a balance-sheet repair mode. The problem is that people are all doing the right things, trying to regain financial health and repair balance sheets. But if everyone does this at the same time, you will kill the economy.
This is what we call the fallacy of composition.
And we must try not to cut stimulus prematurely, because that’s the one huge mistake Japan made in 1997.
When the bubble burst there in 1990, Japan put in a stimulus, so its GDP growth was maintained. Japan’s GDP, by the way, never fell below the peak of the bubble. This is in spite of the fact that its commercial real estate values fell 87 per cent nationwide, and the amount of wealth the country lost was equivalent to three years worth of Japan’s GDP in 1989.
That was a remarkable feat.
But in 1997, the International Monetary Fund and the Organisation for Economic Cooperation and Development told Japan: your budget deficit is too large [and you should stop]. I was advising Prime Minister Ryutaro Hashimoto back then, and I was the only one against cutting the stimulus. I said if you cut, the economy will come crashing down.
But the PM decided to cut. Then Japan had five consecutive quarters of negative growth and a complete breakdown in the banking system. And eventually, Japan’s budget deficit also increased. It took Japan 10 years to bring its deficit back to the level of 1996, to come out of the hole; it wasted 10 years with that one mistake in 1997.
I hope China will not repeat that mistake of removing stimulus prematurely, particularly when the private sector is still repairing balance sheets. Only when private businesses are coming back to borrow, that’s the time to remove a stimulus.
Specifically, to begin with, Beijing should do whatever it takes to complete all unfinished homes. The reason is that if you want to do a big stimulus, you have to come up with a plan for projects you’ll put the money in.
But the planning to identify a pipeline of projects and design them will take time – probably a year and a half. That means you could end up wasting a lot of time during this process when the economy is already faltering.
If the Chinese government uses the money to complete unfinished apartments, this will allow the money to start circulating in the economy faster. Then you bring the best and brightest people in China to come up with new projects that can earn a social rate of return higher than 2.4 per cent.
I say the social rate of return because if the private sector invests in infrastructure projects, it will not collect all of the benefits, because of what economists call externalities, or a consequence of an economic activity that affects other people or things without these effects being reflected in market prices. But the government can collect the externalities.
And why 2.4 per cent? Because the yield on 10-year government bonds in China is 2.4 per cent. So, if the project earns more than that, it will be self-sustaining financially to pay the interest and won’t become a burden on taxpayers in the future. And one of the key characteristics of a balance-sheet recession is that, with the private sector deleveraging, government-bond yield comes down to levels unthinkable in ordinary times.
So, for now, complete all of the unfinished homes. And in the meantime, prepare for financially viable, shovel-ready projects to be launched in a year or so. Delivering homes to these buyers will also boost confidence. Lots of them have put in all their savings as down payments.
China faces deflation pressure, and you have written about the risks of demographic threats and its shrinking labour force. It appears China has all of the symptoms that Japan experienced 30 years ago. If China is facing “Japanification”, what lessons can it learn?
What China is facing right now is a combination of stagnation and a shrinking, ageing population.
Japan’s population was still increasing for 19 years after the bubble burst. But in China, population decline and the bursting of the bubble started roughly at the same time, around 2022 and 2023. So, the Chinese situation is far more serious than that of Japan 30 years ago.
For homebuyers with borrowed money, they want to make sure the value of their apartments will rise. But that’s not the case if the population is declining. In most places throughout China, other than top-tier cities, it’s very difficult to make the argument that home prices will continue to go up.
A declining population is worsening China’s balance-sheet recession because people have reduced expectations of home prices recovering or rising. This is something Japan never had to worry about because its population was still increasing back then.
So, China today could be staring down a deeper cliff because the population decline started at almost the same time as the emerging balance-sheet recession and deflation.
On the other hand, the biggest advantage China has over Japan is that so many Chinese are already talking about a balance-sheet recession. Back in the 1990s in Japan, no one knew anything about this disease. And if the [Chinese] government uses this advantage and puts in a big stimulus, then nothing may happen because the economy may not collapse.
Back in Japan 30 years ago, we never realised that the private sector would choose to minimise debt even at a zero per cent interest rate, because that’s not in our economics textbooks. We wasted so much time doing the wrong things and then allowed the asset prices to collapse.
But if China understands what’s going on, explains to the public that this is a balance-sheet recession, and assures people that the government won’t pull the plug [on stimulus] until private sector balance sheets are repaired, then people will feel safe and will continue to spend and invest.
What do you think is going through Beijing’s mind when assessing the threat of a balance-sheet recession? Are leaders and economic advisers in denial?
Beijing is probably of the view that home prices haven’t fallen all that much, at least as gauged by official statistics, thinking the damage to the private sector balance sheet should not be that large.
But my counterargument is that a balance-sheet recession sets in when people start believing that they are chasing the wrong asset prices. It’s that moment.
When Japan fell into balance-sheet recession in 1990, a lot of people were in denial too. They said real estate prices never fell for the last 55 years so it would just be a small correction. But once people realised they were chasing the wrong asset prices, panicked and changed their behaviour, that was the moment [Japan] slipped into a balance-sheet recession.
Many people in China already feel as though home prices cannot rise further, so they want to deleverage. If people start feeling that this is a bad situation and change their behaviour, then at that moment a balance-sheet recession has arrived.
You have spent quite some time in the US, both in academia and in the Federal Reserve system. Given that the Chinese economy has lost some momentum, some say China may never be able to catch up with the US in GDP. What’s your opinion?
Well, that all depends on if Chinese entrepreneurs are free to pursue their dreams; if there are few restrictions or constraints; if the global market is fully open to Chinese products; and if China is fully open to foreign investments from the US, Japan or wherever. If all of these favourable conditions are still in place, I’m sure China will surpass the US in a few years. But today, unfortunately, that’s not the case.
Many in China are very worried about their own future, and they’ve become very cautious. Foreign markets are becoming less open and less friendly to Chinese products, and foreign direct investment is not flowing into China the way it used to. So, I’m afraid that the day [of China overtaking the US in GDP] may never come if we stay on the current path.
It also appears that geopolitics is something that Beijing’s economic policymakers cannot control. But domestically, Beijing has quite a lot to do, especially on how to further unleash the entrepreneurship of its people to make sure that private businesses can feel confident again to invest.
So, it depends on Beijing’s choice of policies: whether Beijing will continue to put politics and national security above the economy. Beijing has shown quite the tendency to do that.
How should Beijing navigate this external environment marred by geopolitical rivalries and decoupling?
Many Chinese entrepreneurs who previously thought of investing to expand capacity may now feel that foreign markets aren’t as open as before. The US, Europe and Japan, or the “West”, account for 56 per cent of global GDP, and their average per capita GDP is US$60,000. Then there are India, Russia, Africa and Latin America, which represent 26 per cent of global GDP, with their average per capita GDP of US$13,000. So, it’s like 1/5 of the West.
If I were a Chinese entrepreneur selling products, when 56 per cent of the global market is not going to be as open as before, and I have to rely on this remaining 26 per cent, I would be very careful and cautious. I don’t want to invest or expand when I realise there’s no market for it. So, I think that may be one of the reasons why Chinese entrepreneurs are becoming more cautious.
The US government has always judged China not just on how it deals with the US, but how it deals with its smaller neighbours, and it’s there that things are not going very well: recently, with the Philippines, and with all of these other countries, there are a lot of tensions.
I will recommend that China be a little more careful with its neighbours, because Americans and the West are watching very carefully. How China treats its smaller neighbours may affect the degree to which the Western market remains open to Chinese products.
Will we see a further fragmentation of global supply chains and more geopolitical and economic turmoil in the coming decades?
Even if China moves in a different direction, there are so many other countries out there waiting for Chinese factories to come. Vietnam, Indonesia, the Philippines, India, Bangladesh. They all work very hard to make themselves attractive so that more factories will move there, including Chinese ones.
So, this is very different from the first 30 years of China’s opening – what I call the easy part of China’s development, in my book. Back then, China was the only game in town: it had everything going for it, so it became the world’s factory. But today, other countries have learned from China and said: we have to fix our infrastructure and our customs duty procedures, we have to educate our people. And then these countries become big competitors.
If I were the Chinese government, I would drop this belief that, no matter what, foreign companies will come to invest in China. That was true for the first 30 years, but not any more. China has to make itself attractive again so more factories will come and stay in China.
The Chinese market is so big, [foreign firms] should stay in China. But the fact that so many of them are moving out suggests to me that there’s some room for improvement.
So, China may suffer from reduced investments and exports because of all of the decoupling and so forth. But other countries will benefit from it. Vietnam will benefit massively from this. India, Indonesia, the Philippines – they all might benefit from it. China’s misery can be its neighbours’ fortune.
So, if you look at the global economy as a whole, it might not make all that much difference, even though the Chinese economy is slowing down. It’s not like a global catastrophe scenario.
