In recent years, China’s economy has been increasingly characterized by a peculiar phenomenon—one economists have come to term a “balance sheet recession” (a phrase popularised by Richard Koo). While the country’s headline growth figures still appear robust, beneath the surface a quiet deleveraging is underway. In many ways, China’s current predicament mirrors the Japanese experience of the 1990s, yet with notable twists that make its recovery prospects—and policy responses—unique.
The Anatomy of a Balance Sheet Recession
A balance sheet recession occurs when high levels of private debt force firms and households into a deleveraging mode. Rather than borrowing and investing, economic agents divert their cash flows to repaying debts, even when interest rates are near zero. The outcome is a prolonged period of subdued spending and investment that drags down overall growth, leaving government stimulus as the only effective counterbalance
Richard Koo famously argued that while conventional monetary policy might normally spur borrowing, in a balance sheet recession the private sector’s focus on repair rather than expansion renders such measures largely ineffective. In Japan, the collapse of asset prices in the early 1990s triggered this very shift, with companies and households choosing to cut back on spending in order to rebuild their balance sheets
China’s Debt Dilemma: Signs of a Quiet Crisis
Much like Japan decades ago, Chinese companies and households are now caught in a deleveraging spiral. Prior to 2015/2016, private sector borrowing hovered around 7% of GDP while household savings were about 10% of GDP—a balance that allowed for steady economic expansion. However, as corporate debt levels became unsustainable and asset prices—especially in the property sector—began to falter, firms started to pay down debts aggressively. With borrowing slowing sharply around 2015, local governments have increasingly stepped in to fill the financing gap, borrowing to support infrastructure projects and other public investments
For instance, recent data indicate that by the end of 2023, the debt growth for Chinese households and corporations was only 6.9% and 9.1% year-on-year respectively—figures that stand in stark contrast to previous trends, and underscore a broader deleveraging trend [globaltimes.cn].
Leverage, Unborrowed Savings, and the Vicious Cycle
At the heart of a balance sheet recession is a structural shift in behavior: when too many agents simultaneously switch from borrowing to saving, overall demand contracts. In China, decades of rapid credit expansion have led to an overhang of debt. Now, as asset prices fall and expectations change, companies are prioritizing debt repayment over new investments, resulting in an excess of “unborrowed savings.” This phenomenon—where the private sector’s natural inclination to deleverage deepens the economic downturn—is a familiar refrain from Japan’s lost decade
Moreover, leveraging has historically been a double‐edged sword. In booming times, high debt can amplify growth; but when confidence wavers—as it has in China—the same indebtedness forces a drastic pullback, with deleveraging triggering a further decline in demand and asset prices.
Parallels and Divergences: Japan then and China Now
There is little doubt that many indicators of China’s current state resemble Japan’s experience in the 1990s. In both cases, asset bubbles—particularly in real estate—burst, leading to a dramatic contraction in asset prices. In Japan, the collapse left companies with negative equity, forcing a lengthy period of debt reduction that prolonged economic stagnation
Yet there are critical differences. For one, Japan’s recession was predominantly a corporate crisis; its firms were highly overleveraged, and the deleveraging process was almost universal. In China, while many large property developers have faced severe balance sheet problems, much of the financing gap is now being picked up by local governments. This divergence is significant: whereas Japanese companies slashed borrowing almost uniformly, China’s local governments have become major borrowers in their own right, often financing infrastructure to prop up the economy [globaltimes.cn].
A senior official once noted, “When every company is cutting back, you have a situation where even healthy balance sheets are forced into saving mode. But if the government can borrow and spend, it provides a counterweight. In China, this dual dynamic is both a blessing and a curse” [english.phbs.pku.edu.cn].
The Shifting Balance of Borrowing and Saving
Before the mid-2010s, the relatively balanced relationship between borrowing and saving allowed the Chinese economy to expand steadily. Private sector borrowing at around 7% of GDP, coupled with household savings near 10%, provided a cushion that enabled sustained consumption and investment. However, as the real estate sector began to falter, confidence waned, and companies started aggressively paying down debt, this equilibrium shifted.
Local governments have increasingly stepped into the breach, borrowing to finance public projects in a bid to offset the contraction in private demand. This change in the composition of borrowing—from the private sector to local government channels—is a critical difference that has significant policy implications.
The Limits of Indirect Stimulus
In its attempt to counteract the downturn, China has deployed a host of policies aimed at stabilizing asset prices and incentivizing spending. Aside from traditional monetary easing, Beijing has launched measures such as cash-for-clunkers schemes, subsidies for technology upgrades, and other indirect incentives designed to boost consumption and investment without resorting to massive direct fiscal spending. These policies are designed to avoid exacerbating the debt overhang while trying to kick-start the economy [bnnbloomberg.ca].
Yet critics argue that such measures, while helpful in the short term, may not address the underlying deleveraging problem. Without a significant injection of demand, even these well-intentioned policies may only offer a temporary respite.
Hesitancy in Direct Spending: A Calculated Caution
Despite mounting pressure, Chinese policymakers have so far been reluctant to embrace large-scale direct fiscal stimulus. This hesitancy stems from a combination of factors. First, there is the risk of further inflating asset bubbles in a market that has already seen dramatic price swings. Second, a significant direct spending program could exacerbate long-term debt problems—China’s government debt-to-GDP ratio was around 85% in early 2024, nearly triple the level seen during the 2009-10 stimulus phase
Furthermore, the structure of China’s economy—with its mix of central planning and market forces—means that direct spending risks being misallocated if the channels between central policymakers and local implementers remain too disconnected. This structural disconnect, while not as extreme as in the Soviet era, still poses a significant challenge [en.iiss.pku.edu.cn].
As one prominent economist noted, “If the government borrows the unspent savings and channels them directly into the economy, it could spark a rebound. But if the process is too top–down, the inefficiencies inherent in the system could lead to wasted resources and further imbalances” [scmp.com].
Fiscal Stimulus: The Last Resort?
Direct fiscal stimulus—while theoretically the most effective way to restore demand—remains a measure of last resort. Historical experience from Japan shows that premature or excessive reliance on direct spending can have perverse effects. In Japan’s case, cuts in stimulus in 1997, just as deleveraging was in full swing, deepened the recession and prolonged stagnation by nearly a decade.
In China’s context, many policymakers fear that a similarly aggressive fiscal program could create long-term structural distortions. For now, China appears to be content with a “wait and see” approach, using indirect measures to support the economy while hoping that improvements in the property market and consumer sentiment will eventually reverse the deleveraging trend.
As Richard Koo once cautioned, “Fiscal stimulus must be deployed as a careful, measured response to an economy starved of credit—if it’s deployed too soon or too aggressively, it can do more harm than good” [english.phbs.pku.edu.cn].
Looking Ahead: A Path Out of the Recession?
What, then, is the outlook for China? The answer is far from straightforward. The balance sheet recession that is unfolding is not just a temporary glitch—it could well be the beginning of a prolonged period of low growth and persistent deflation reminiscent of Japan’s “lost decade.” Yet China also has advantages Japan did not: a vast untapped potential in household consumption, a burgeoning middle class, and a capacity for rapid policy experimentation.
For instance, structural reforms aimed at easing the financing constraints on private companies and enhancing local government accountability could help steer the economy back onto a growth trajectory. Moreover, with the global economy increasingly looking to diversify away from traditional manufacturing hubs, China’s own dynamic might evolve in unexpected ways [bbvaresearch.com].
Nevertheless, until these reforms are implemented, China’s current approach—favoring indirect stimulus measures over direct fiscal outlays—remains a bet on its ability to self-correct without triggering the very downward spiral that has haunted Japan for so long.
Concluding Thoughts
China stands at a crossroads. Its current balance sheet recession, characterized by a frenzied pullback in private borrowing and an overreliance on local government financing, poses profound challenges. While lessons from Japan’s experience offer valuable insights, China’s unique institutional framework and rapid policy adjustments mean that the outcome is by no means predetermined.
As leaders like Richard Koo have warned, an effective recovery will require a careful balancing act—a combination of targeted fiscal support, monetary easing, and, crucially, structural reforms that bridge the gap between central planning and local implementation. For now, Beijing’s reluctance to engage in large-scale direct spending may buy time for reforms to be enacted, but it also risks prolonging the downturn if unborrowed savings continue to pile up. In this delicate dance between deleveraging and growth, the stakes could not be higher.
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