Balance sheet recession: Can China avoid Japan’s fate of the 1990s?

Peter Bachmann

· Opinion Pieces

(Re-published with the permission of the author. Check out Peter here)


In the late 1980s, Japan was on the way to become the new top economic power in the world. “Made in Japan” conquered the markets in the United States, Europe and Asia with innovative consumer and industrial products and superior cars.

With a strong currency, which, ironically, was a result of the Plaza Accord imposed by the US in 1985, Japanese companies went on a buying spree abroad. Sony’s acquisition of Columbia Pictures or Mitsubishi’s purchase of the majority of the Rockefeller Center have been the most prominent of the many Japanese investments in the United States.

At home, the real estate market went through the roof. In 1989, the grounds of the Tokyo’s Imperial Palace was said to be worth more than the entire state of California, and golf club memberships sold for more than one million USD. The stock market made people rich. Between 1985 and 1989, the Nikkei almost quadrupled in value.

But this couldn’t last. After the asset and stock market bubbles burst in the early 1990s, Japan’s economy came crushing down. Commercial real estate prices collapsed and fell 87% nationwide to a level last seen in 1973. Wealth of about ¥ 1,500 trillion, worth three years of the 1989 GDP, was destroyed.

The corporate sector, and subsequently the households, were forced to repair their balance sheets. They used their cash flow and salaries to pay down debt and increase savings. As a result, investments and spending were neglected. The money stayed in the financial system and did not circulate in the economy. The Bank of Japan’s support mechanisms didn’t have the desired impact since the corporate world and households refrained from borrowing money despite record low interest rates. The priority was no longer profit maximization, but debt minimization.

The economy stagnated and remained in an environment with low growth, low investment and low interest rates, initiating Japan’s ‘lost decade’.

In 1997, Richard Koo, an economist at Nomura, coined the term Balance Sheet Recession, which he used to describe what happened to the faltering Japanese economy after the bubble burst.


In his own words, a Balance Sheet Recession occurs when:

“a debt-financed asset bubble bursts, the private sector enters a period of deleveraging, monetary policy becomes ineffective because lower interest rates still do not incentivize the private sector to borrow, and fiscal policy becomes key.”

Given China’s current economic situation, the question arises how likely it is that the second largest economy in the world will face a similar fate in the years to come.

Koo argues that China’s economy shows similarities to Japan’s at that time.

According to Koo, who cites official data from the National Bureau of Statistics and the People’s Bank of China, Chinese companies started reducing their borrowing costs drastically from 2016 onwards. Why this happened is not clear. Koo believes that it could be related to the start of the trade frictions with the United States. As a result, the regional governments had to step in and borrow to support the economy.

Consumers are reluctant to spend

According to a recent McKinsey report, “household savings rates are still significantly higher than pre-COVID levels (34 percent versus 30 percent), with limited signs yet of the additional RMB 53 trillion in savings accumulated since 2020 being funneled into consumption.”

The consumer price index (CPI) is negative, and reached a new low in November with -0.5% year-on-year.

The producer price index (PPI) is negative throughout the year and has fallen to -3% year-on-year in November

Interest rates have been lowered

In recent months, the one-year loan prime rate was cut twice during summer and now stands at 3.45% (in early 2020, it was set to 4.15%). This rate is used for household and business loans. The five-year loan prime rate remained unchanged at 4.2%. It is used as a peg for the country’s mortgages. In early 2020, it was as high as 4.80%.

- The budget deficit is increasing. In November, China announced an increase of its 2023 budget deficit to around 3.8% of GDP, up from 3%. Official reason: The planned issuance of RMB 1 trillion (USD 137 billion) in sovereign bonds. Compared to the United States or major European nations, China’s budget deficit compared to its GDP is still low but growing.

- The total debt-to-GDP ratio (including household, corporate and government debt) continues to rise. By the end of 2021, the ratio was 262.8%. A year later it hit 273.2%. Michael Pettis, who is a professor of finance at Peking University’s Guanghua School of Management, writes that the debt ratio is approaching 300% at the end of 2023 and argues that it could go up to 450% or higher within a decade. Household debt is estimated to have doubled in the last 10 years to 64% of GDP.

- The economy is growing because of government-led investments. This often requires throwing good money after bad, for example for infrastructure projects that add little value to the overall economy. In the last year investment made up between 42-44% of total GDP. This is far more than in any other major economy.

- Official growth figures have fallen to 5% or below for most of the year. While this is not low by any standards except China’s, it is a continuation of a downward trend that has started years ago. And, as mentioned above, if the economy expands mainly because of investment-led growth, it is neither financially sustainable, nor does it follow the government’s own plan, which calls for “high quality” or “healthy” growth drivers, consisting of consumption / services. The “low quality” growth drivers such as cheap manufacturing, exports and investment, should take a back seat, but there is little indication that this is happening in earnest any time soon.

How can China avoid a Balance Sheet Recession?

According to Koo, China enjoys a big advantage over Japan. 30 Years ago, nobody knew what happened to the Japanese economy and how to stimulate it for the long run. Koo himself only came up with the term “Balance Sheet Recession” in 1997. While Japan lost years analyzing how to best counter the sluggish economy with basically no borrowers, China today has the advantage of knowing exactly what needs to be done. There is only one way to avoid a Balance Sheet Recession (according to Koo), which is a long lasting fiscal stimulus.

Compared to industrialized countries where 80% or more of the population live in urban areas, China’s urbanization rate stands at 64%. This means there are still hundreds of millions of people living in rural areas with lower living standards and income levels. They too want to have a better life and enjoy what a higher salary can buy. Urbanization can be a growth driver for the years to come.

China has other advantages too. Unlike the provincial governments, the central government has a much lower debt level. According to Rhodium, it is 21.3%. It therefore has the power to expand its fiscal policy and support the economy for as long as it takes.

And this is exactly Koo’s point.

As Koo argues, China’s central government can avoid a Balance Sheet Recession since it has the financial might to react quickly and with determination, drawing from Japan’s bitter experience. He believes that the government knows what policies are needed to solve the problem. What they need to do, according to Koo, is to announce a long lasting fiscal stimulus.

If Koo is correct, we can expect a major fiscal stimulus in the first three months of 2024. The question remains whether the government is going to do it.