Is China repeating Japan's mistakes?
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The big question is what happens next. The best policy is for banks to write off losses early and replenish their capital. Chinese banks now have strong reserves and growth potential, but so did Japanese banks in 1989.
The important thing is to be transparent and to force banks to take action early. If non-performing loans are hidden and losses are not dealt with, then the problem becomes larger and before long it overwhelms the banks' capital buffer. Japan's mistake should not be repeated.
The best way to deal with a bubble is to prevent it from bursting, rather than trying to contain the damage once it does. The larger the bubble is, the more difficult it is to manage. The best way to prevent a bubble from becoming larger are to raise interest rates, tighten bank loans to real estate developers and second-home buyers, and require banks to increase capital as their credit expands.
However, raising interest rates will invite more short-term capital inflows. Therefore, interest rate hikes must be combined with floating of the RMB. One-time appreciation and flexibility are recognized ways to stop dangerous inflows of short-term capital.
If China resists appreciation of the RMB, the likelihood of repeating Japan's mistakes will become higher.
The author is a Professor from Graduate School of Economics of the University of Tokyo.
