The Blind Leading the Blind?
I like to think that modern China's economic transformation has a shared heritage with that of Japan, cemented by Deng Xiaoping's visit in 1978. This was the first ever by the head of a Chinese government. I am sure that the then Prime Minister, Fukuda Takeo, warned China's "little bottle"4 of Bismarck's precautionary advice to his nineteenth century predecessor Iwakura that national independence can be compromised by an excessive reliance on foreign creditors. Superior investment prospects are one thing, but not when they entail persistent current account deficits and a dependency on the fickleness of foreign capital. You better believe Bismarck's lesson was rudely brought home to the Asian Tigers one hundred years later.
Power not Profit
Japan, however, heeded the instruction. From then on it chose to subordinate everything else in its domestic economy to the success of its export sector. Only by such sacrifices, it believed, could it hope to independently acquire the necessary foreign exchange required to pay for imported capital equipment and the industrialisation of its economy. This was when the 'P' for sovereign power came to supplant the dominance of the Anglo-Saxon demand that capital be allocated according to the 'P' for profit.
Every creditor nation needs a transformational event. For Japan it was the First World War, which displaced the warring European nations as competitors during a time of huge Allied military demand. The opportunity produced a boom for Japanese products. From 1915 to 1918, Japan went on to accumulate a current account surplus that eventually represented over half of its GDP at the onset of war. Buoyed by such financial success, it was able to complete a rapid upgrading of its manufacturing base without the need for overseas debt.
China's transformational event arguably came with its admittance to the World Trade Organisation (WTO) in 2001 and the coincidence of yet another overseas conflict, the Federal Reserve's monetary battle to stem the economic fallout from the TMT crash. The spur to Chinese demand from low American interest rates and the willingness of Western society to take on more financial leverage was even more startling than the absence of European competition in the Pacific in the early part of the twentieth century. From 2001 to its peak in 2007, China accumulated a current account surplus of $1.7 trn, a sum equivalent to one and a quarter times the size of its economy back when it entered the WTO.
One must wonder whether Chinese policy makers have considered what happened to Japan after World War I. We all know that world demand sagged after the conflict. Europe bounced back and began producing competitive, non-military products once more. Eager to earn precious foreign currency to repay war debts, European manufacturers proved surprisingly price competitive in an attempt to recapture their lost market share. The environment should have prompted caution. However, perhaps imbued by the hubris of their startling and unprecedented expansion, the Japanese bureaucrats saw things differently. They could not accept the obvious and immediate dangers arising from the fall-off in demand. Neither were they afraid of the commercial implications from a resumption of international competition. Instead they pressed on, raising the stakes further, by directing the private sector to borrow and invest in yet more excess production capacity and to build and store more inventories.
Not only was Japan operationally leveraged to global growth, it was simultaneously becoming financially leveraged as well, as its banks financed the post-war expansion. The nation had also become internationally contentious; the industrial capacity built during the run up to the war was far greater than the sum of the domestic and foreign markets' ability to absorb it. As would happen again sixty years later, Japan was deemed to be predatory in stealing jobs from the West as trade tension was fanned by high unemployment in the austerity bedraggled economies of Europe. But ultimately it was its domestic financial vulnerability that led to Japan's undoing. The excess capacities never produced the cash flows necessary to service or retire the debt, and with unsold inventory piling up, companies began to default on their loans. A bank run ensued in 1920 and the rest of the decade was mired in low and disappointing economic growth.
