Chinese Economists Push Back On ‘Balance Sheet Recession’ Risk

Chinese economists are pushing back against the idea that the economy is entering a “balance sheet recession” like Japan did decades ago, with possible implications for how Beijing will deal with its faltering recovery.

(Bloomberg) — Chinese economists are pushing back against the idea that the economy is entering a “balance sheet recession” like Japan did decades ago, with possible implications for how Beijing will deal with its faltering recovery. 

The concept as defined by Richard Koo, an economist at Nomura Research Institute, says that businesses and consumers, spooked by falling asset prices, start to pay down their debt instead of investing or spending in the economy. Last month, Koo said China was falling into a balance sheet recession since households and firms are no longer borrowing. 

Several influential Chinese economists disagree, saying borrowing has slowed rather than halted, and that is the result of weak consumer and business confidence. Deflation in the prices of goods and services is also more of a threat than falling asset prices, they add.

The arguments by the Chinese economists, who are government advisers or have consulted with senior officials, could have implications for policy. In Koo’s diagnosis there is close to zero role for monetary easing, with fiscal policy the only solution. The Chinese economists agree that fiscal support should increase, but some also think interest rate cuts can be used to help businesses whose debt-servicing burdens have been worsened by deflation.

Koo’s scenario isn’t borne out by the official data so far. China’s central bank reported that households and companies outstanding loans grew in the first half of the year, meaning new borrowing exceeded repayments. Loans to non-financial companies increased by 2.8 trillion yuan over that period, the People’s Bank of China’s data shows.

“I don’t think China is witnessing a balance sheet recession,” Sheng Songcheng, formerly a senior official at the central bank, said in an interview. 

Sheng argues that debt is growing even relative to the total economy, pointing to a 1.4 percentage point increase in the household leverage ratio – the amount of household debt relative to gross domestic product – in the first quarter of the year, based on data from the PBOC and the National Bureau of Statistics. 

Those who back Koo’s argument and warn of the “Japanification” in China point to signs that firms are holding on to more cash. That is “an early sign of balance sheet recession,” economists at Natixis SA said in a report last week. UK-based Fathom Consulting said in a note that China “could be at the beginning” of Koo’s process.

Luo Zhiheng, chief economist at Chinese brokerage Yuekai Securities Co., argues that Koo’s theory doesn’t apply to China, since weaker demand for credit has less to do with damage to households’ balance sheets, and more to do with a lack of confidence. He was part of a group of economists consulted by Premier Li Qiang this month.

A weak economy and worries over jobs and incomes means consumers are less confident and more frugal, Luo argues, which in turn has reduced business income. He cites factors such as US-China tensions and unpredictable government regulation for the decline in business sentiment. 

Consumers and firms are boosting precautionary savings, setting off a vicious spiral of lower investment, which further reduces income and spending, Luo wrote in a recent note.  

Low inflation has also led to higher real — or inflation-adjusted — interest rates, limiting corporate appetite for borrowing, Luo said, meaning rate cuts would help businesses.

China’s fiscal policy has been slightly contractionary this year compared to 2022, and the PBOC cut interest rates just once, while providing targeted liquidity toward specific sectors like property.  

Liu Yuanchun, president of Shanghai University of Finance & Economics, who previously advised China’s president Xi Jinping, said last month that China isn’t seeing a “balance sheet contraction of all market players in a comprehensive and synchronized way.” Companies in sectors like electric vehicles, batteries and solar power are still borrowing rapidly in order to expand, he said. 

“The current problem is to break the vicious circle between lack of aggregate demand, lower prices, and lower confidence,” he said.

In an article last week, Liu argued that falling producer prices are pushing real interest rates for businesses as high as 8%. A “relatively large” reduction in interest rates remains a “magic weapon” to revive the economy, he wrote. 

Chinese economists agree that like Japan in the 1990s, falling property prices in China since Beijing tried to cool the sector in 2021 have left households with a higher ratio of liabilities to assets, which has damaged their their balance sheets. 

Koo sees falling asset prices as the trigger for a shift in mindset among Japanese businesses and households toward attempting to “repair” balance sheets, by cutting spending and paying off debt.

But in China’s case, the decline in property prices has been less severe. The contraction in China’s second-hand home prices moderated to 2.79% on-year in June, compared to a 5% drop when Japan’s housing market crash was at a similar stage.

China’s equity price declines have also been milder. The CSI 300 Index is down about 25% from its mid-2021 peak, compared to a 40% drop in the Nikkei 225 index in the 18 months following its December 1989 high.

“Asset prices haven’t plunged,” said Liu Lei, a researcher at the National Institution for Finance and Development, a think tank which advises China’s government. “China is not in a technical balance sheet recession,” he said.

–With assistance from Yujing Liu.

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