Japan, thanks to enormous credit growth in the 1980’s became a popular destination of investors. The price of real estate in Japan skyrocketed. Land prices jumped 1000%. The Nikkei-their stock market index shot up to 38500 from less than 10000 in a very short period of time. All of a sudden the party came to an end. The boom of the economy made the banks to take unlimited risks. After the boom of the 1980’s the Japanese economy decelerated in the 1990’s. Bad loans soared. This took the banks and the bureaucrats by surprise. The Japanese banks concealed the truth. For example, they said that the size of bad loans was a mere 8 trillion Yen. By 2000 this increased to 100 trillion Yen. The Japanese government and the banks went into denial. Faith in the Japanese economy significantly changed.
The investors from around the world ran away from the Japanese markets. Nikkei briefly touched 5000 when the PE ratio almost dropped to single digit. All kinds of explanation were given to justify the collapse. Japan has not fully recovered yet. They are into permanent deflation with little growth possibilities if there is any.
Incidentally this pattern happened in the US in the early 2000 which took their banks by surprise. A large number of both large and small banks went belly up. In a way it could be said that the US failed to see the parallel of Japan’s experience to its own.
What lessons can China pick up from both Japan and the US?
China is currently experiencing spectacular growth in credit growth and the property prices reflected the price of the 1980’s. China is trying to transform a bank centered state controlled financial system to western type capital markets. What lessons should China learn from Japan?
1. Deceleration – The growth rate of China is expected to be around 7% and is heading lower. Deflation has been deadly for banks. China’s producer prices have been falling for the last 26 months but at least the consumer price is positive. So China should be able to manage deceleration.
2. Domino effect: China should be prepared to handle a couple of small banks failure and like in Japan it could spread.
3. Deposit insurance – Currently there is no deposit insurance scheme. All account holders could face risk of default. China should introduce its own FDIC.
But the striking feature of China is that they are sitting on 2.5 trillion dollars in their reserve. With this extraordinary financial power China can recapitalize their bank. China has experience in this regard. They did this in 1999 when there was a mini crunch.
How can China bring its economy to a slower growth rate without creating any bank failures? They know what happened in Japan and in the US in 2008. They may use quantitative easing to bail out their banks.
Now what can India learn from this? A lot. Our commercial real estate is a big bubble. Property prices are already falling in big cities like Bombay and Delhi. If the inflation continues to remain unabated RBI will have no choice other than to increase interest rates. The effect will be that our real estate prices will come down crumbling. Already according to RBI our non-performing assets of the public sector banks stand at 5% of the amount available for lending. We have to assume that RBI is telling the truth unlike Japan. We will have to wait and see how this crisis will pan out.
Mr. Modi’s government has an insurmountable task of solving the mess the UPA government has created. Let us hope he succeeds as our future depends on it.