Japan holds an important lesson for China. Like the People’s Republic today, it battled with runaway debts in the early 1990s. The key is to tell banks whose loans are going bad: if you must, then extend – but don’t pretend.
The first part of that message is already being put into practice. Chinese regulators and the central bank recently suggested that banks should roll over credit to troubled local government financing vehicles if they can’t pay interest or principal. This is reminiscent of the Japanese experience. After the bubble in Japanese stocks and property burst, companies did shed debt. But the deleveraging dragged on. Banks kept making new loans to debt-laden borrowers so the latter could keep repaying old liabilities.
This “evergreening” of soured debt was not a bad strategy in itself. Tokyo commercial property prices in early 1993 were down 22 percent from their peak two years earlier. Like in China, land was the main collateral for loans. If banks had forced companies to repay them by selling land, about a fifth of the Japanese corporate sector’s 1990 net worth would have vanished overnight. Even that is a conservative estimate, because land prices eventually slumped by 80 percent over two decades. If the pain had to be taken all at once, the prosperity that the Japanese society has managed to preserve despite a massive loss of wealth may not have continued.
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