Is China Heading for a 'Lost Decade'? Lessons from Japan and Insights for Investors

Overview

Many professional investors believe China might soon face a situation similar to Japan’s “lost decade” in the 1990s. During that period, Japan's economic growth stagnated, and prices consistently declined, a phenomenon known as deflation. At first glance, lower prices may seem like a good thing, imagine grocery shopping and finding prices cheaper every week. But deflation reduces consumer spending, business profitability, and overall economic activity, leading to prolonged stagnation which is why it was labelled a “lost decade.”

If China were to experience a similar economic slowdown, it could have a profound impact on the global economy, affecting everyone from large investors to everyday people. Professional investors are signalling concerns about China's future by trading Chinese government bonds, particularly long-term ones. To understand their significance, let’s first explore how bonds work.

What Is A Bond? 

A bond is essentially a loan. When you buy a bond, you’re lending money to the issuer, which could be a government or a corporation. In return, the issuer agrees to pay you interest (called a "coupon" and is the cost of borrowing) at regular intervals and repay the original amount (the "principal") on a specified date, known as the bond's maturity.

Bonds have been around for centuries, used historically to fund wars and rebuild economies. Today, they are a major part of global finance. As of September 2022, the global bond market was valued at a staggering $133 trillion. Below you can see a visual capitalist’s chart depicting how bond market debt issuance is divided.

Now that we know what bonds are, let’s discuss why investors care about bond yields, a crucial concept in analysing economic trends.

What Are Bond Yields?

Bond yields measure the return an investor earns on a bond. To calculate yields, investors evaluate the future cash flows from the bond, interest payments and the repayment of principal and adjust for the time value of money (the idea that money today is worth more than the same amount in the future) and other risks associated with lending.

The yield reflects compensation for two things:

1. Time risk: The cost of waiting to receive money in the future.
2. Credit risk: The possibility that the issuer might default or fail to repay the loan.

Yields are influenced by investor perceptions of risk. For example, lending to a financially stable government like the U.S. for a short period typically carries a lower yield compared to lending to a riskier entity for the long term. This perception of risk and economic conditions forms the basis of how investors interpret government bond yields, such as those of China. These yields can also reveal how investors see the future economic conditions of the borrowers. Now, let’s look at what is happening with Chinese bond yields and how investors view the future of China's economy.

What Is Happening With Chinese Bonds?

Recently, the yield or potential return on Chinese long-term government bonds fell below that of Japan, a historic shift.

Historically, analysts have looked at long-term government bond yields, particularly 30-year bonds, to estimate future economic health and risks of deflation. For instance, during the European debt crisis, the yields on Greek 30-year bonds were monitored by investors to look for any future potential deflation in the Greek economy and European Union, hence it was a key indicator for investor to measure fears about a country's economic stability and potential deflation going forward.

In China's case, lower yields indicate that investors see lending to the Chinese government as less risky or are betting on prolonged economic stagnation and deflation.

This trend has been referred to as the “Japanification” of China and draws comparisons to Japan's deflationary spiral in the 1990s. Here’s what investors are expecting:

• Economic slowdown: China’s growth has been and will likely be sluggish, with minimal price increases.
• Central bank action: The People’s Bank of China has and will continue to cut interest rates (the cost of borrowing) to encourage borrowing and spending to stimulate the economy

Before we jump into what could happen if China also goes into deflation like Japan as expected by the bond market investors lets look at what actually happened in Japan and see if China has similar situations.

What Actually Happened In 1990s To Japan?

After World War II, Japan experienced incredible economic growth, often referred to as the "Japanese Miracle." From 1955 to 1990, Japan’s GDP grew eightfold, and many believed Japan could eventually overtake the U.S. as the world’s largest economy. However, this rapid growth came to a stop due to a massive real estate bubble.

But What Exactly Is A Bubble?  

In financial markets, a bubble happens when the price of an asset, like real estate, stocks, or even something unusual like tulips rises far beyond its actual value. This happens because of psychological factors: as prices rise, more and more people jump in, afraid to miss out on profits, further inflating prices. But, like a soap bubble, this can’t last forever. When reality hits, the market “pops,” and prices crash, leading to major losses. A classic example of this was the Tulip Mania in 1630s Holland.

At the time, tulips were seen as a luxury item, and demand caused prices for tulip bulbs to skyrocket. At its peak, the rarest tulip bulbs sold for six times the average person’s annual salary. However, by February 1637, the market collapsed, leaving many people ruined. Now, imagine something similar happening on a much larger scale with Japan’s real estate market.

Japan's Real Estate Bubble

During Japan's economic boom, real estate prices surged to extreme levels. At the peak, the 3.4-square-kilometer Imperial Palace in Tokyo was valued higher than all the real estate in the U.S. state of California. Gains from Japan’s real estate and stock market amounted to $3.4 trillion, equal to 40% of Japan’s GDP.

But then, the bubble burst. Real estate and stock market prices crashed, causing widespread economic damage. This, combined with Japan’s aging population and declining birth rates, led to a deflationary trap, a situation where prices kept falling, discouraging spending and investment.

Deflation, as we’ve discussed earlier, is when prices fall consistently over time. While this may sound good at first, it creates a vicious cycle. When prices are expected to keep falling, people delay purchases and companies delay investments, which weakens the economy further. To counter this, Japan’s central bank, the Bank of Japan, set interest rates to 0% or even negative.

Negative interest rates mean the government essentially pays you to borrow money, hoping you’ll spend or invest it. Despite these efforts, Japan remained in a deflationary environment for decades, with little economic growth. Only recently has the Bank of Japan begun raising interest rates, signalling some recovery from the situation.

Similarities With Current Chinese Situation

Just as Japan experienced exponential growth before its economic troubles, China’s economy has also expanded at an incredible pace over the past few decades. However, similar patterns are emerging in China that mirror Japan's path to economic slowdown and deflation, particularly in the real estate sector.

In China, an estimated 70%–80% of household wealth is tied up in real estate, making it an even more significant part of people’s financial lives than it was in Japan during its bubble. As China's economy grew rapidly, so did its real estate market, with property prices skyrocketing. Many families relied on real estate as their primary investment and source of financial security. However, this heavy reliance created vulnerabilities.

China’s real estate market began to unravel under the weight of extreme debt taken on by property developers. A high-profile example is Evergrande, one of the country’s largest developers, which collapsed under massive debt obligations. The bursting of this bubble has left homeowners and investors feeling significantly poorer, as over 80% of household wealth is tied to real estate.

This "wealth effect" impacts consumption: when people feel poorer, they spend less, reducing domestic demand. Lower demand leads to fewer jobs, particularly in real estate and related industries, and for those still employed, pay cuts of up to 90% are becoming more common.

Adding to these challenges is China’s aging population and declining birth rates, another critical factor in Japan’s lost decade. A shrinking workforce and lower population growth weaken long-term economic prospects and contribute to deflationary pressures.

These factors are leading investors to draw strong parallels between China and Japan’s economic struggles in the 1990s. and bond market investors are also predicting the same.

What Does a "Japanified" China Means For You And The Global Economy 

While we discuss potential deflation like Japan, we should note that China is the world’s second-largest exporter, and its economic slowdown has implications far beyond its borders. With weaker domestic demand and falling prices, the People’s Bank of China has been cutting interest rates and will likely continue to do so. This devalues the Chinese Yuan, making Chinese exports cheaper for global buyers. In theory, this should boost export-focused Chinese companies, as their products become more affordable internationally.

For everyday consumers, this could mean cheaper prices on imported goods. Those popular Shein or Temu hauls you see on TikTok might get even more affordable.

China is not just an exporter, it’s also a major importer of commodities like iron ore. Weaker domestic demand in China could hurt global commodity exporters, particularly countries like Australia, which rely heavily on Chinese demand. Lower Chinese imports could ripple across global supply chains, reducing revenues for key trading partners.

China’s stock market has also been underperforming, much like Japan’s during its deflationary period. The CSI 300 Index, which tracks the 300 largest companies listed on the Shanghai and Shenzhen stock exchanges, has delivered poor returns over the past three years.

This reflects the broader economic slowdown, and the challenges Chinese companies face in a weaker economy.

For investors, this underperformance, combined with the looming risk of deflation, signals caution. Just as Japan’s stock market stagnated for decades, Chinese stocks may face similar challenges soon.

Even hopes of cheaper Chinese exports may not fully materialize. With President Trump recently re-elected and promising new tariffs on Chinese imports, the benefits of a weaker Yuan could be offset. Additional 10% tariffs on day one, would make these exports more expensive for American buyers, counteracting the expected price drop from currency devaluation.

Things May Be Different This Time

While the bond market loudly screams deflation in China, some value investors, those who focus on finding undervalued (market underpriced) or ignored stocks see potential opportunities. But before we dive into this, let’s examine a key difference between China today and Japan in the 1990s.

China’s economy and government are far more centralized under the Chinese Communist Party (CCP). This centralized structure allows for rapid policy changes. For example, after initially stating no stimulus would be provided, the government quickly reversed course and announced cash injections and eased housing regulations all in just one day.

Although these measures have so far failed to overcome the economic slowdown, they demonstrate the government’s flexibility and capacity to implement larger stimulus packages in the future. This aids the view of China’s economic struggles as an opportunity to buy undervalued stocks.

For instance professional investor Howard Marks of Oaktree Capital recently suggested in an interview with Bloomberg that this downturn could be temporary, offering a chance to buy Chinese stocks at lower prices. This Contrarian investing or going against popular market sentiment has been a successful strategy for some.

However, before you rush to invest in Chinese stocks, remember the words of renowned economist John Maynard Keynes: