A Tale of Two Economies: Japan’s Revival and China’s Uncertain Future

Long-term bond yields typically indicate investors’ expectations for future economic growth and inflation. The switch signals hope that Japan’s economy may return to more sustainable economic success while indicating caution about China’s economic trajectory. 

How could the long-term economic outlook appear brighter for a highly developed country with a population of 125 million than for the world’s largest emerging economy with 1.4 billion people? Near-term growth in China will likely face challenges due to ongoing trade tensions with the United States, but the long-term outlook is shaped by underlying economic fundamentals. Viewed through this lens, Japan’s comparatively favorable outlook becomes more understandable.

Pillars of Success

Successful economies share several fundamental characteristics. First, as Nobel laureates Daron Acemoglu, Simon Johnson, and James A. Robinson have demonstrated, these economies have strong institutions that facilitate broad economic participation. Second, as their research also uncovered, these countries ensure stability through the rule of law.¹  Finally, as extensive economic research has underscored, successful economies are fundamentally market-based. The absence of any of these three critical elements can impede economic momentum. 

Japan has these pillars and had become a breakthrough economic success during the second half of the 20th century. It achieved developed economy status by the 1960s and continued to advance into the 1980s.

Eventually, debt dynamics, demographics, and the 1985 Plaza Accord that revalued the yen led to the burst of Japan’s famous asset price bubble and a historic balance sheet recession. Japan’s average annual growth rate has amounted to only 0.77% over the last 30 years, while inflation was on average only 0.42% a year. 

Over the same three decades, China’s economy expanded at an annual average rate of 8.48%, while inflation amounted to 3.67% annually. When Japan’s economic growth stalled, China took up the baton; the market reforms that had been initiated by Premier Deng Xiaoping unleashed one of the greatest periods of wealth generation the world has ever seen. 

The bond market reflected the growth differential. Japanese 30-year government bonds yielded on average 0.98% annually from 2016–2024, while their Chinese counterparts yielded an average 3.34%.  

Reversal of Fortune

Now the tables have turned.

Japan has cleaned up bank balance sheets and overhauled corporate governance rules. Its monetary policy remained loose throughout the post-COVID-19 inflationary shock, and currency weakness imported further inflation, ultimately driving wages higher. Today, the economy is normalizing: Inflation is around 3.6%, and growth is picking up. With the three pillars of long-term success in place, the outlook for Japan has brightened. 

In contrast, China’s growth engine sputtered after the financial crisis in 2008, although fiscal stimulus pumped through its economy for another decade. The pandemic dealt a severe blow to the economy, leading to numerous city shutdowns. To keep growth on its planned path, China had to take on significantly more debt on an aggregate level. Across all sectors, the total debt-to-GDP ratio has soared to 289%, a record high for the country and significantly greater than all other emerging markets at 126%.²  This debt profile is not expected to improve soon: Fitch Ratings downgraded China’s credit in early April in part because the country is likely to employ sustained fiscal stimulus to support growth amid low demand, deflationary pressures, and higher US tariffs.³  China’s demographic picture is also changing as its working-age population begins to contract, and this is projected to accelerate in the coming years.  

Where Is China Heading? 

Some investors draw parallels between Japan’s economy 30 years ago and China’s current situation. However, while successful economies share common traits, each struggling economy faces unique challenges.  

China’s first obstacle to achieving sustained economic success is that it has only one of the three essential pillars. From a bottom-up perspective, China’s economy is market-based, which has driven remarkable growth over the past three decades. However, the other two pillars—robust institutions and the rule of law—are less firmly established. The absence of these critical supports has contributed to China’s current predicament. A significant misallocation of capital in the housing sector led to a bubble that has since burst and will likely take years to resolve. Additionally, government efforts to curb private profit and wealth from 2020 to 2023 stifled China’s entrepreneurial spirit in the process. 

China’s economy now faces the risk that growth momentum may not be enough to escape the middle income trap.⁴  Smaller countries such as South Korea and Singapore successfully transformed from low-skilled manufacturing to high-income economies. In contrast, China’s vast size and heavy reliance on exports mean it would need to drive significant portions of the global economy through the middle-income trap alongside it to fully consolidate its wealth gains. 

This challenge is exceptionally difficult, and the bond market remains cautious. China’s 30-year yield of 1.89% points to stagnation at best. The emerging economy will need to find a new equilibrium, but the question is whether the adjustment will be a swift one followed by sustainable growth, or a prolonged political and economic crisis. The latter scenario would be detrimental not only for China but the world at large.  

Several developments over the first quarter have been encouraging. President Xi Jinping has reversed course on the private sector’s progress, explicitly encouraging technology business leaders to innovate. The government has also pledged to support the country’s major banks and officially prioritized efforts to boost consumer demand. In our view, however, deeper structural reforms are needed to set the economy on a path to long-term success—and the sooner these are implemented, the better. 

What Does It Mean for Investors?

Japan and China, two influential economic powerhouses, are navigating critical turning points in their development. The movement in their long-term bond yields provides a window into the economic landscape and highlights broader themes of transformation and growth. For investors, understanding these dynamics and interpreting the economic narratives can uncover potential opportunities that arise during these economic shifts.