China isn't turning Japanese

China’s debt mountain has investors worried that it will go the way of Japan. In the late 1980s and early 1990s a debt-driven market crash led to decades of deflation and economic malaise the Japanese are only just beginning to escape. But, for all the superficial similarities with the Japan of then, there are good reasons to believe that China will avoid the same outcome.

In the decades leading up to its stock market crash, Japan grew relentlessly. Annual per capita GDP growth averaged 5.7% between 1950 and 1989. Unfortunately, debt also grew. By the first quarter of 1990, private debt in excess of its long-term, non-linear trend was 23% of GDP.

The ensuing debt bust triggered not only decades of deflation, but depressed Japan’s economy. Since 1990, average annual per capita growth has slumped to a mere 0.9%.

Market watchers are now seeing echoes of those Japanese developments in China. Between 1979 and 2024, the Chinese economy grew on average by an annual 7.7% per capita (albeit on a downtrend during the past decade). But that too came with a massive build-up of debt. Since 2008, debt as a proportion of economic output has more than doubled to 280% from 130% (see Fig. 1). By the first quarter of 2016, excess private debt peaked at 26% of GDP.  That also broadly marks the point at which Chinese economic growth began to slow. Its equity market has slumped 45% since peaking in January 2021. And the spectre of deflation is looming over the economy, so much so that Beijing has had to ramp up both monetary and fiscal stimulus measures.

China isn't Japan

A deeper look into the numbers, however, shows fundamental differences between where China is now and where Japan was 35 years ago. Here a bit of theory is needed.

There are three channels through which excess debt can lead to chronic deflation. First, there’s the financial channel where there are forced sales of assets to repay the debt. Then there’s the monetary channel through which liquidity in the economy contracts as crisis prompts people to hoard money. And, related, there is the credit channel, where company defaults damage banks’ balance sheets and cause them to rein in lending. In the absence of official intervention to provide emergency liquidity and repair banks’ balance sheets, each of these mechanisms risks feeding a default cycle and embedded deflation.

Typically, the residential property market is most at risk. And here, China isn’t nearly at the same extremes that Japan was on the cusp of collapse. In 1990, Japan’s residential property valuations peaked at 450% of GDP. By contrast, China’s peaked at 324%,  and have since dropped to 265% in 2024 (see Fig. 2). Furthermore, China’s residential market seems to be broadly in balance relative to the rest of the economy – China accounts for 20% of the world’s residential values, only a little more than its 18% share of world GDP.

Nor is the forced sale of equities as much of a risk to China now as it was to Japan then. Japan’s market capitalisation rocketed in the late 1980s to peak at 137% of GDP, representing 40% of the world’s market capitalisation – at its peak the Japanese market was worth more than the US’s. That compares to Chinese equities, which represent 9% of total global market capitalisation today and 64% of the country’s GDP.

China, following its own path

So if China isn’t going the way of Japan, what’s the likely outcome?

Intriguingly, in the 66 episodes of excess debt identified by our research, recessions followed peak debt levels in only 58% of the cases. When there was no recession, countries that saw deleveraging also saw the average growth rate contract just 0.8 percentage points over the following seven years. So a Japan-style deflationary trap isn’t necessarily a typical course.

The drop in trend growth tends, in part, to be a function of the accumulation of capital during boom years. The decline in the marginal return on capital should, however, be partly offset by both cross-sector productivity – migration from the countryside to cities – and productivity improvements within sectors thanks to innovation.

Policy choices also play a part. Japanese monetary policy remained persistently tight even after its property bubble burst, with the real interest rate often rising above the country’s real growth rate. By contrast, although there is scope for the People’s Bank of China to losen policy further, it has ensured that the real interest rate is below the real growth rate.

One of the consequences of Japan’s excessively high interest rates was the yen’s continued appreciation even as the economy was stagnating, creating a millstone for the country’s export sector. By contrast, the renminbi isn’t expensive, which means Chinese goods remain competitive. What’s more, even under the threat of US tariffs, China is unlikely to be bullied into something akin to the 1985 Plaza Accord,  the global agreement that forced up the value of the yen.

Additionally we also expect Beijing to launch another round of stimulus at its next party congress in March. This is likely to be equivalent to 2% of GDP, which should ensure the country’s growth meets the government’s 5% target this year. Official efforts at shoring up two of the economy’s weak spots – local government and the banking system – will help prevent a slump in both credit creation and credit demand.

China certainly has its problems. But despite a large rise in domestic indebtedness during its boom years, the resulting rebalancing won’t lead to a Japanification of the Chinese economy. Beyond the headlines, the situations aren’t analogous and nor is the policy response likely to be. China is very unlikely to suffer lost decades to debt deflation. In 2024, China’s national output was 63% of the US’s. By 2030 we expect that proportion to rise to 73%.

Echo Chen contributed to this article.