NEW YORK (TheStreet) -- When China began to pursue a floating yuan exchange rate again and open up its financial markets in 2010, it seemed as though it would proceed slowly and that it had done its homework and learned from the abrupt manner in which Japan's economic rise ended at the start of the 1990s. But the current crisis in China reveals that the country failed to read the writing on the wall.
The Japanese Banking Crisis
Every banking crisis begins with bad loans. And bad loans happen because of the dodgy standards of the institutions that provide them: banks. An International Monetary Fund working paper from 2000 clearly concluded that this was indeed the cause of the banking crisis in Japan.
On one hand, Japanese banks used dubious standards to make bad loans seem legitimate. On the other, they used counterparties to prevent bad loans from appearing on their balance sheets. All of this led to a credit boom fueled by bad loans. And, as bad loans always do, these ended badly, resulting in the Japanese banking crisis.
But here's the thing. The IMF working paper indeed demonstrated the direct cause of the crisis, but it failed to explain the reason why Japanese banks took on more risk and lowered their credit standards to dangerous levels. It was the Bank of Japan's tactic to count on a weak yen for growth from the 1960s to the 1980s. And when a currency is constantly devalued and inflation is way above normal levels for so long, banks have a huge incentive to take on bad loans and ignore red flags, in order to allow their earnings to catch up with inflation.
The problem is that even when inflation cools, the shady standards remain. And this is what happened in Japan. Inflation eventually moved into a normal range, and the yen was allowed to strengthen, but Japanese banks already had a bad risk culture. The strong yen led to a slowing down of exports, which hit growth, and when growth is slow, it's hard to mask bad loans. So the crisis erupted.
What China Never Learned
When looking at the causes of the Japanese crisis, it's obvious what China should have done beginning decades ago. It should have settled for less growth in the past few decades and allowed a floating currency from the start, which would have created a more transparent banking system that was able to cope with risks.
Instead, China failed to resist temptation and counted on a weak yuan for too long, until it reached a point where banking standards became so shady that, at the moment, no one really trusts the numbers Chinese banks release. And just as in Japan, China's crisis actually erupted when the yuan was strong and falling exports couldn't hide the nation's fragile banking system.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.