Recently, many investors have been discussing the balance sheet recession that began in Japan in the early 1990s and are concerned that China’s economy may face a similar situation. But what exactly is a balance sheet recession, and how did it occur in Japan?

The story began with the appreciation of the US dollar (on a trade-weighted basis) by nearly 80% between 1980 and 1985. During this period, the US Federal Reserve raised interest rates to combat inflation, leading to a widening interest rate differential between the US and other industrialized countries. This attracted capital inflows, causing the US dollar to strengthen. To alleviate the economic pressure caused by the stronger dollar, the US government convened a meeting in September 1985, attended by finance ministers and central bank governors from France, the UK, Germany, and Japan. The result was unanimous agreement to systematically assist in the devaluation of the US dollar.

While Japan agreed to help weaken the US dollar, the Japanese government also feared that a stronger yen would negatively impact exports and, consequently, the economy. To counteract this, the Bank of Japan decided to lower interest rates to stimulate consumer demand and offset the effects of the stronger yen. However, the interest rate cuts also stimulated the rise in asset prices.

At that time, it took three generations for an average family to repay a home mortgage. The value of the land of the Imperial Palace in central Tokyo was so high that it could have bought all the properties in Manhattan, New York. The Japanese government began lowering interest rates in the mid-1980s, but it wasn’t until mid-1987 that they realized that property prices were overheating and attempted to control them by raising interest rates. The overnight rate in Japan gradually increased from 3.3% in mid-1987 to 8.3% in March 1991. The continuous rate hikes burst the real estate bubble.

As property prices began to decline, and with the yen exchange rate significantly higher than a few years earlier, many Japanese companies found it increasingly difficult to conduct business. If companies don’t reduce their debt level, the elevated interest rate might send them to bankruptcy. Japan’s corporate debt-to-GDP ratio reached 139% in 1990, significantly higher than the 63% for the US, 96% for France, 60% for Germany, and 58% for the UK. Debt and the economy are intricately linked. When companies and individuals use increased borrowing to invest and consume, it stimulates the economy. However, when both prioritize debt repayment, the funds available for investment and consumption decrease, hampering economic growth. Japan’s per capita GDP remained around 4 million yen from 1992 to 2012, with little to no growth. If not for the government continuously increasing borrowing for investment, Japan’s per capita GDP in 2012 might have even been lower than in 1992.

When property prices and the economy decline, it’s not only companies and individuals that are affected. If property prices fall sharply to the point where assets no longer cover debts, banks also begin to suffer from bad loans. This makes them more cautious and conservative in lending, ultimately slowing down the entire economic system.

So, will China experience a balance sheet recession?

There are significant differences in economic structures between China and Japan. From the corporate debt level perspective, as of 2021, the corporate debt to GDP ratio in China is approximately 131%, ranking second compared with G7 countries, which is relatively high. However, according to a 2022 S&P research report, about 75% of corporate debt in China belongs to state-owned enterprises. If state-owned enterprise debt is treated as government debt, the non-state-owned enterprise debt ratio to GDP is only 31%, lower than all G7 countries.

These calculations don’t mean that state-owned enterprises won’t face problems. However, if state-owned enterprises encounter debt issues, the government is likely to provide full assistance, and the chances of state-owned enterprises defaulting or deleveraging are relatively low. Of course, in the long run, for state-owned enterprises to develop healthily, they need to improve their operational efficiency and ultimately approach the level of private enterprises. If state-owned enterprises’ operating cash flow is insufficient to repay debt over the long term, and debt continues to accumulate, they could become zombie enterprises, leading to a continuous rise in national debt and a decline in economic efficiency.

As for personal debt, although personal debt in Japan decreased slightly from 1990 to 2010, the reduction was marginal compared to corporate debt. The ratio of personal debt to GDP only decreased from 68% to 61%. In the US, the ratio of personal debt to GDP reached 99% before the global financial crisis in 2007, then gradually declined to a low of 75% in 2019. In China, the ratio of personal debt to GDP at the end of 2021 was 62%, slightly lower than Japan before its balance sheet recession and significantly lower than the US before the global financial crisis.

From this perspective, the scale of corporate and personal debt in China is smaller than that of Japan and the US before they experienced economic crises. Additionally, China’s banking system is largely state-controlled, so as long as the government relaxes monetary policies, it’s unlikely that banks will be unwilling to lend. Therefore, despite the current fragile economic atmosphere in China, we believe that the government has the capability to prevent a balance sheet recession from occurring.

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Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.

One of the most discussed topics among investors recently is mainland China’s inflation rate. In May, the consumer price index rose by 0.2% year on year (YoY), much lower than the 4% YoY rise in the US and 6.1% in Europe. It is also lower than other emerging countries such as Indonesia (4%) and India (4.3%).

From an economic standpoint, the ideal level of inflation is generally around 2-3%. If inflation remains persistently high, it not only affects business investment sentiment but also impacts low-income individuals and those who rely on savings for their livelihoods. However, if inflation is too low, it increases the risk of deflation, which can lead to asset price declines and economic contraction. Moreover, since debt levels generally do not decrease, deflation significantly reduces borrowers’ repayment capacity and increases banks’ bad debt risks, which will weaken their willingness to lend.

While the rest of the world is grappling with inflation, why is China moving in the opposite direction, hovering on the edge of deflation? There are three possible reasons. First, as the world’s factory, intense competition among companies in China leads to a tendency for excessive investment in production capacity. When Western countries shifted their expenditure from goods consumption to service consumption after the pandemic, their import from China declined. Therefore, Chinese manufacturers face increasing challenges in utilizing their production capacity. Overcapacity naturally leads to deflationary pressure. Second, high energy price is a significant factor driving inflation in Europe and the US. However, China benefits from Western sanctions on Russian oil and it purchases oil from Russia at prices much lower than the international oil price. Third, Western countries exercised ultra-loose monetary policy during the pandemic to stimulate household consumption. In contrast, China’s stimulus policy was relatively reserved, resulting in much lower inflationary pressures compared to Western countries.

China’s current inflation rate is only 0.2%, almost negligible. The real concern for China is how to avoid falling into the deflation trap. In addition to the three factors mentioned above, deflationary pressure in the country is also partially due to insufficient domestic demand. In recent years, the central government has tightened economic controls for national security reasons and to reduce the economy’s reliance on real estate, indirectly affecting consumer confidence. Currently, people are more willing to save their money in banks rather than spend them. The ratio of household net savings to GDP, after deducting debt, has increased from 32% in early last year to 44% in March this year. Encouraging consumer spending is now the government’s top priority. In the early 21st century, the South Korean government encouraged credit card companies to relax their approval requirements to stimulate the economy and promote advanced consumer spending. Although it eventually led to a credit card repayment crisis, it showed that there are effective measures the government can take if it truly wants to promote consumption.

If consumer spending remains insufficient, reference can be made to the measures taken by the US in the 1930s and Japan in the 1990s to combat deflation. Both countries employed Keynesian economics by borrowing idle funds from the public through government intervention in the market and using them for infrastructure investments to drive economic growth. The Hoover Dam, located in the suburbs of Las Vegas, was built during this period. While infrastructure investments may not always generate sufficient momentum to bring the economy back on a growth trajectory, at the very least, they can help reduce the risk of the economy entering a vicious deflationary cycle.

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Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.