By Wei Gu

HONG KONG, Nov 4 (Reuters) - Everyone agrees that China's

economy must be rebalanced, but few have bothered to delve into

the costs. Japan's experience has shown that even well-meant

changes could sow the seeds for a bubble.

China cannot stay with its current economic model forever.

But as the economy has become extremely unbalanced, to some

extent even more so than Japan's in the 1980s, rocking the boat

too much risks tipping it over. Instead of rushing into changes,

it would be better to make reforms gradually.

Most observers believe an extremely loose monetary policy

was the root cause of Japan's bubble. But Tomo Kinoshita, an

economist at Nomura, reckons that efforts to liberalise the

economy, such as sharply revaluing the yen, developing a deeper

bond market and deregulating interest rates were among the

fundamental reasons behind the bubble.

The challenges facing China's economy are similar to those

seen in Japan in the 1980s. Foreigners are calling for a

currency revaluation because the undervalued yuan gives China's

exports an extra boost. Capital markets need to play a bigger

role because investment has been directed mostly by state-owned

banks.

True, property price increases appear to be milder than in

the Japan of the 1980s. Household loans only account for 30

percent of disposable incomes in China, versus about 90 percent

in Japan in 1989, according to Nomura. But there are warning

signs. New mortgages recently hit a record. And ratings agency

Fitch has cited China's property market as a cause for concern.

The Chinese stock market also looks less overvalued than

Japan's did. The ratio of Chinese stock prices to earnings is

only a third of the peak levels reached in Japan. Stock market

capitalisation as a percentage of GDP is 62 percent, much lower

than Japan's 150 percent at end of 1989. But China is catching

up fast, and the ChiNext market, China's long-awaited

Nasdaq-style market, debuted last week with a speculative surge.

Moreover, China has been more aggressive in terms of

monetary easing as it tries to prop up the economy while waiting

for exports to return. The broad money supply in China has been

rising at almost 30 percent this year, twice as much as in Japan

back in the 1980s. So if there is a bubble, it could grow bigger

than the one in Japan.

Even much-needed efforts to liberalise and rebalance the

economy may lead to asset price inflation. Similar to China,

Japan's banks were too big and small companies had trouble

getting financing. So developing a corporate bond market and

encouraging banks to lend more to small firms was seen as a

healthy change.

But policymakers underestimated the negative impact on

banks. After Japan developed a liquid corporate bond market,

large corporations issued cheap equity-linked bonds to repay

bank loans. Because Japanese financial institutions lacked other

revenue sources, they targeted smaller corporations and

consumers. Total bank loans made to small- and medium-sized

companies and individuals rose to 71 percent of total loans in

the late 1990s from 47 percent in the late 1980s.

Due to a lack of information on their new clients, the

banks' bad loans started to rise. Their lending standards

deteriorated as they scrambled to make up for lost business.

This could very well happen in China as the country encourages

consumers to take on more debt to stimulate domestic demand.

Moreover, Kinoshita argues that in Japan interest rate

deregulation 'put a cat amongst the banking pigeons' because

banks were forced to lend out more when their margins became

compressed due to more competition. Pressure from the United

States played a role, and the Japanese authorities were eager to

internationalise the yen anyway. Letting banks set deposit and

lending rates was one of the requirements for the yen's

internationalisation.

The policy lesson for China is that when Beijing takes

business away from banks, it needs to balance things out by

allowing them to take on new business, such as securities

underwriting and broking.

But that leads to the question of how to compensate

securities firms for their lost business and prevent them from

engaging in reckless behaviour. This just underscores the

complexity of China's problems.

Most of the world believes that China risks moving too

slowly, not too fast. President Barack Obama might give Chinese

leaders another ear bashing during his upcoming trip to China.

But without the right systems in place, big bang reforms could

be disastrous. It is important that China, as well as the rest

of the world, learns from Japan's mistakes.

-- At the time of publication Wei Gu did not own any direct

investments in securities mentioned in this article. She may be

an owner indirectly as an investor in a fund --

(For previous columns, Reuters customers can click on

(Editing by David Evans)

http://blogs.reuters.com/wei-gu/ Keywords: COLUMN CHINA/

(wei.gu@thomsonreuters.com; Reuters messaging wei.gu.reuters.com@reuters.net; +852 2843-6352)

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