During her recent visit to Beijing, International Monetary Fund head Kristalina Georgieva connected the dots between China and Japan in ways that Xi Jinping’s inner circle probably didn’t appreciate.
While urging President Xi to make the “brave choice” of accelerating structural reforms to transition China to a consumption-led model that relies less on exports, Georgieva highlighted the need to end the property crisis that’s fueling deflation.
“China is simply too big to generate much (more) growth from exports, and continuing to depend on export-led growth risks furthering global trade tensions,” Georgieva told reporters about the US$19 trillion economy. “It requires brave choices and determined policy action.”
Then, she pivoted to the “Japanification” risk of it all, urging Beijing to let unviable property developers fail, if needed. “We have been urging more attention for closure on this problem,” Georgieva explained. “We call them ‘zombie firms.’ Let the zombies go away.”
To be sure, comparisons between Japan and China are hardly ideal. For one thing, Japan’s deflation troubles were many years in the making and stemmed from a titanically larger pile of bad loans hobbling the banking system and policymaking malpractice across several governments. China’s property reckoning is more of a post-Covid-crisis phenomenon.
Yet as Japan has taught the world, the longer debt overhangs are allowed to fester, the more entrenched deflation becomes. China’s falling-price troubles are about to enter a fourth year.
The problem, however, is that China faces a lost-in-translation issue. It’s entirely possible that Xi and Premier Li Qiang are acting boldly behind the scenes to stabilize China’s property sector. Yet pledges by Xi and Li are no longer enough. Chinese households and global investors alike are increasingly concerned that Beijing is overconfident in its ability to avoid a Japan-like lost decade.
Changing this perception is key to ending deflation. One of Team Xi’s top pledges, for example, has been to prod households to deploy the US$22 trillion of savings they’re sitting on. This, however, requires building a robust, sizable social safety net to encourage consumers to spend more and save less.
It also requires reviving the property sector. With roughly 70% of Chinese household wealth wrapped up in real estate, stopping the financial bleeding is vital to increase spending so that Beijing can maintain 5% economic growth.
Barring bold and credible plans to put a floor under real estate and give 1.4 billion Chinese reasons for economic optimism, deflation could continue to fester.
It’s a complicated issue, of course. Not all deflation is bad. In Japan, households came to regard sliding prices as a stealth tax cut. These days, of course, Tokyo faces the flipside of the problem as inflation rises at roughly 3%.
This makes the Bank of Japan the economic equivalent of the dog that caught the car. Many consumers are actually missing deflation as stagflation erodes living standards.
In China’s case, many economists have argued that weak prices could benefit technology companies looking to expand, high-dividend stocks and exporters with diversified businesses.
Still, the overcapacity that China is exporting is irking trading partners — particularly the tariff-wielding US. And the excessive price competition that Xi is struggling to stamp out — so-called “anti-involution” — is taking on a life of its own.
It’s high time Xi’s economic team got a handle on deflation once and for all. And to head off the nation’s nascent zombie problem as soon as possible.
In a new study by the Federal Reserve Bank of Dallas, economists Scott Davis and Brendan Kelly argue that “there’s mounting evidence of ‘zombie lending’ in China, banks rolling over bad loans to unprofitable firms and allowing the status quo to continue rather than recognize losses.”
In many ways, they assert, “the current experience in China mirrors that of Japan in the 1980s and 1990s. Rapid growth in private sector debt—also fueled by domestic savings—was followed by the appearance of zombie lending. In Japan, that zombie lending led to the inefficient allocation of capital and decreased productivity, especially in sectors shielded from foreign competition.”
Chinese authorities, the economists point out, have announced a high-profile anti-involution campaign in 10 leading manufacturing sectors. Its success will be important in limiting the share of zombie assets in the manufacturing sector.
Yet, the Dallas Fed warns, “the higher zombie share in services may be equally important at a time when authorities pursue tentative efforts to rebalance the economy in favor of consumption and services. While policies include some direct support to households, a key focus appears to be boosting investment in services, including through subsidized loans.“
Sonali Jain-Chandra, a top IMF China economist, argues that the key is to accelerate “reforms to rebalance demand toward consumption and further open the service sector, which can promote sustainable growth and help create jobs.”
While “China’s economic development over the last several decades has been remarkable,” it “has relied too much on investment as opposed to consumption,” Jain-Chandra says.
Slowing productivity and an aging population risk limiting growth, which we expect to slow significantly in coming years. A comprehensive and balanced policy approach is needed to address these challenges. Given these circumstances, Jain-Chandra says, China’s service sector is an “underexploited driver of growth” needed to revive economic confidence.
There’s an argument, too, that the People’s Bank of China must act more assertively to add liquidity to the economy. In November, the level of credit expansion in Asia’s biggest economy remained subdued. Financial institutions issued just 392 billion yuan (US$55.7 billion) in new loans, well below expectations for a 450 billion yuan (US$64 billion) increase.
Last month, household loans contracted for the second consecutive month. It was the first time that happened since Beijing began keeping records in 2005. Corporate borrowing remains lackluster, too. Fixed-asset investment is on track for its first annual decline since at least 1998.
“We expect credit growth to remain weak over the coming months,” says economist Leah Fahy at Capital Economics.
Earlier this week, the PBOC signaled it would maintain its supportive monetary policy stance, but not much more. In many ways, the PBOC is limited by political considerations — including fears a weaker yuan might exacerbate trade tensions with Washington.
Also, Xi has long sought to reduce leverage in the financial sector and, at least in theory, provide less aid and comfort to corporate zombies. Yet in the year ahead, odds are high that the PBOC will become more active in battling deflation.
The effort must be accompanied by Team Xi cleansing developers’ balance sheets.
“Short of significant structural reform of its economic system, Beijing is running out of ways to escape producer price deflation,” says economist Camille Boullenois at Rhodium Group. “Its main tools – directed use of the domestic financial system and large-scale fiscal support – are now less effective than in the past and arguably close to exhausted.”
As a result, Camille Boullenois notes, “it seems unrealistic to assume that deflationary pressures will ease and China’s real exchange rate will appreciate in the near term. The focus, therefore, should be on the PBOC’s management of the currency against the US dollar and a trade-weighted basket of currencies.”
Still without bold structural reforms that alter incentives, increase competitiveness and level playing fields, monetary easing alone won’t reverse a major economy’s falling-price troubles. Or the zombie risk bedeviling policymakers as 2025 staggers to a close.
Follow William Pesek on X at @WilliamPesek
