Why China Must Cut Interest Rates

Summary

• China’s unbalanced economic recovery is down to policymakers keeping interest rates above the natural rate.
• High rates have pushed capital into financial markets and real estate – sectors perceived as low risk. The high cost of financing has also supressed household demand, leading consumer spending to lag the wider economic recovery.
• Policymakers have been reluctant to cut rates because it will exacerbate financial risks, but a digital yuan that improves Beijing’s control over money flows will allow it to act.

The idea that China must cut rates seems like a non-starter. It was the only major economy to clock positive GDP growth last year.

But examining what drove the country’s recovery reveals a more worrying picture.

Even by the year’s final quarter, China’s economy was still massively unbalanced. Financial services and real estate took a historically large share of nominal GDP growth, as both benefited from the looser credit environment earlier in the year.

In contrast, business services and consumer-facing industries – which derived fewer benefits from China’s looser monetary policy stance – accounted for a lower share of GDP growth than in previous years.

China’s problematic monetary stimulus meant that Beijing was wary of pulling too hard on this policy lever, increasingly leaning on fiscal spending instead. The outsized contribution of IT services to 4Q20 GDP growth was one result of that, with officials ramping up ‘new infrastructure’ spending in areas like 5G base stations.

Yet fiscal stimulus was also problematic. Government spending disproportionately benefited areas where inefficient state-owned enterprises (SOEs) were dominant. This skewed economic activity away from the private economy. FAI at private firms rose just 1.0% y/y in 2020 vs 5.3% y/y growth at SOEs.

The private sector – outside of real estate and finance – deriving such little benefit from Beijing’s monetary or fiscal stimulus last year meant these firms relied on price cuts to generate demand.

That almost no price growth accompanied China’s strong real GDP growth print last year has received insufficient attention. Excluding the agricultural sector, where supply issues have heavily distorted prices, China’s inferred GDP deflator in 4Q20 was minus 0.3%.

Interest Rates Are Too High

A significant cause of these problems is interest rates being too high. This is supressing demand and forcing companies in sectors that do not benefit from government stimulus to cut prices.

The high cost of capital also means that money flows into ‘low risk’ financial and real estate assets, where Beijing’s reluctance to allow meaningful price falls keeps returns artificially high and risk artificially low.

High funding costs also mean that financial markets are reluctant to lend to ‘riskier’ private entities. And these firms have little incentive to borrow given the elevated borrowing costs and a moribund business environment. Return on assets (ROA) at private manufacturers last year was 6.3% versus the average interest rate on general bank loans of 5.3%. Between 2011 and 2016, private manufacturers enjoyed an average spread of 5.4% between ROA and lending rates.

This situation is unsustainable. With much of the private sector – particularly in the consumer space – reliant on price cuts to generate demand, these firms have little incentive to expand and hire new workers, even as orders rise. Such corporate retrenchment undermines consumer confidence, hindering any recovery in spending. That is why retail sales growth in China started to turn down again at the end of last year.

More Growth, More Risks

Looming deflation is also bad news for China because it is highly leveraged. The country’s misfiring monetary stimulus which, despite Beijing’s best efforts, has spilled out into overleveraged and risky areas like real estate compounds those financial risks. Moreover, these problems with monetary stimulus have forced policymakers to ramp up fiscal spending. The required scale of spending is now so massive that it risks encouraging local officials to throw money at unneeded infrastructure projects for the sake of boosting growth.

In other words, Beijing’s stimulus policies are generating long-term financial risks alongside short-term growth. This either ends in bust or a period of retrenchment to work through these risks.

Beijing needs a change of plan, and it is hard to see how this can be anything other than a move to lower rates across the board.

But how do rate cuts sit alongside Beijing’s recent policy shift to financial de-risking, which last week pushed interbank repo rates to a five-year high?

A digital yuan can square this circle. It would give policymakers better control over money flows, meaning that rates could be cut and a credit stimulus unleashed without funds flowing into risky sectors like housing and financial markets. A digital yuan could also enable Beijing to broaden fiscal stimulus away from infrastructure spending. Authorities could use digital yuan to give funds directly to households, limiting its use to specific areas and even putting a time-limit on spending.

Interest rate cuts in China seem to be the last thing on the markets’ mind at the moment, leaving potentially significant implications for CGBs and the yuan.