Last night the PBoC surprised the market with its biggest rate cut since 1997. Lending rates for one year or more were cut by 108 bps, while the six month lending rate was cut by 99 bps. Deposit rates were also cut, but with smaller cuts in short term rates (36 bps for demand deposits) and bigger cuts for long term rates (126 bps for five year deposits). The market was expecting the rate cut, but did not expect it to be so big.
One of my students asked me yesterday what I thought the stock market reaction would be. I gave him what by now has become a fairly standard response from me. The market will surge tomorrow, I told him, but within a few days it will give it all back. For the record on Wednesday the market rose 0.4% (perfectly retracing Tuesday’s decline).
In fact I underestimated the speed of the market’s response. It did surge this morning, racing up 6.6% in the first fifteen minutes of trading, but then spent the rest of the day drifting down, to close the day at 1917.9, up 1.0% for the day.
I am not sure why the market gave up the gains so quickly, but I suspect that at least part of it may have been recognition that the big cut reflects government fears about the pace of the slowdown. If the government is so worried, investors tell themselves, perhaps they should be too. In that light, an article in today’s Bloomberg discussed an NDRC warning today:
China’s economy is deteriorating more quickly as the impact of the global financial crisis spreads, underscoring the need for “forceful” measures to support growth, the nation’s top planner said today.
“Some economic indicators weakened further in November, showing a faster decline,” Zhang Ping, chairman of the National Development and Reform Commission, told a briefing in Beijing. “In order to curb an excessive economic slowdown, we must adopt forceful measures that have a noticeable impact.”
The dramatic rate cut was, presumably, one of the “forceful measures”. As for the “noticeable impact”, for a long time I have assumed without thinking about it too much that cutting rates was generally expansionary, and so was either a good thing in an economic contraction or, at worst, neutral. This certainly seems to be the case in the US. I have been thinking a little more about the impact of the rates cut, however, and wonder if it really is the same in China. The structure of the Chinese economy and banking system is very different, and so it might not necessarily be the case that a rate cut will do what the government hopes.
A large interest rate cut of this nature creates losers and winners. Savers of course are losers, because they will earn less on their savings. The macro question, I think, is how lower returns on savings will affect domestic household consumption. On the one hand one can argue that it reduces the incentive to save, and so may encourage households to step up their consumption. In that case the rate cut would be good because it helps boost domestic demand.
But there is another view. I think my friend Dan Rosen, a professor at Columbia University, made this point a year or so ago in a different context, but he argued that reducing the return to savings may actually cause households to increase their savings since it will take them longer to achieve whatever long-term savings objective they have. If I earn less on my savings, in other words, I need to save more (and consume less) today to ensure that when I retire I have whatever I think I will need to ensure a comfortable retirement. The fact that savers in China for many years have earned negative real rates of interest may be one reason that consumption is low in China. The erosion of the real value of existing savings means that households have to save more just to stay even.
Today in my Money and Banking class at Peking University we discussed the cut in interest rates and its possible impact on consumption and production. A young lady got up and told us that her aunt had been disturbed by the rate cuts. She was saving money in order to have a certain minimum amount for her son when he enrolls in university, and she complained that with the rate cuts she now needed to increase the amount she saved. Several other students nodded emphatically, suggesting that they had heard similar things at home. This is not a random sampling of Chinese households, of course, but it does suggest that the impact of the rate cut on discouraging saving is going to be mixed, at best.
In the end this is not a theoretical argument but a purely empirical one. The impact a rate cut will have on household savings is whatever it turns out to be, but for now we can’t predict with much certainty its impact on boosting consumption. If any of my blog readers know of useful studies on the subject, I would appreciate a citation or link.
The winners in this rate cut, of course, are borrowers. Their cost of funding has just declined substantially. Here, however, I am afraid that the effect of the rate cut on Chinese economic problems might be different than expected.
The first and most obvious point is that this rate cut will provide breathing space to over-indebted borrowers, of whom I suspect real estate developer are a large part. This may slow down the tendency to liquidate real estate, which is clearly good for the market in the short-term, but it also slows down the adjustment – and perhaps allows overbuilding to continue a little longer. This is good if the crisis is a short term one, but bad if it drags on for at least another couple of years (which I think it will).
Of course it is not just real estate developers who are affected. In the US, a rate cut usually boosts both production, by lowering the cost of capital for businesses looking to create capacity, and consumption, by making it easier for consumers to finance purchases, especially large purchases (homes, automobiles, etc). In that sense rate cuts are likely to be expansionary because they increase demand.
Here in China, however, the consumer loan market is so small that I suspect the impact on consumption will be much smaller – perhaps it may encourage some home buyers, but not much more. Most lending in China goes to the productive sector – businesses. In that case it would be easy to argue that interest rate cuts are more likely to boost production than consumption.
At first that would seem not to be a problem. In the US, for example, anything that boosts the likelihood of businesses to borrow and build factories is unquestionably good for the economy. As they produce more, they employ more workers, which boosts demand. They sell the additional production mainly to the larger US consumer base, who can obtain cheaper consumer financing, and who still consume more than they produce (i.e. the US runs a trade deficit).
But is this the case in China? I have argued that, viewed from the global balance of payments model, China and the US suffer from opposite problems. The US has consumed far more than it produces and China has produced far more than it consumes. The decline in US household consumption means that China (and perhaps the US government) needs to boost demand, or else they will see a contraction in production that entails firing workers and closing factories.
Because bank lending in China is far more oriented towards production than towards consumption, I am not sure that an interest rate cut in China will have the same demand impact that it does in the US. More worryingly, it might have a disproportionately large impact on boosting supply of manufactured goods. In a sense, lowering interest rates can be seen as subsiding borrowers, except that in China most borrowers are producers, not consumers.
Do we really want to subsidize more production? I need to think about this more, but my instinct tells me that lowering interest rates in China may actually exacerbate the global imbalance between production and consumption.
A better policy action than lowering interest rates may be something that was hinted at in an article in today’s People’s Daily:
China’s economic planning agency said on Wednesday the country may raise the income of residents to create more favorable conditions for people to spend more. The government would improve the consumption environment and work on people’s anticipation of future spending, an unidentified official of the National Development and Reform Commission (NDRC) said in a statement posted on its website.
However, the official did not give further details on these measures. “To carry out policies that stimulate domestic demand is a very important footing of the country to weather through the global financial turmoil,” he said.
He continued to argue that such policies to bolster domestic demand should persist for a long time, as the policies play an important role in spurring the economy right now and will also boost market confidence and increase the momentum of the economy in the long run.
Ok, this does not seem very substantial, but the fact that it was posted – however anonymously – on the NDRC website and displayed prominently in both Xinhua and the People’s Daily may suggest that this is not some minor afterthought, and that perhaps there is more to come. It is consumption, not production, that everyone’s efforts should be aimed at boosting.
With inflation dropping like a stone and could easily approach zero and deflation, it isn’t terribly surprising that the PBOC is slashing nominal interest rates in order to reduce very high real rates. The Chinese government had been trying to slow down the economy and inflaiton through the summer and the exogenous shocks in the banking sector and equity markets has had a totally unprecedented impact on economic activity – US consumption in particular — since mid-September.
As the October and November data come out, it is becoming clear just how drastic the impact is. So China is trying hard pull up and out of what was an orderly slowdown turned into a steep dive. Is it useful to say that the Chinese government is panicing? Is it useful to say that the US FEd and Treasury are panicing? Let’s keep perspective.
These governments are just doing what needs to be done to prevent disaster, suffering and systemic failure. And in China’s case, to deal with problems not directly of their own making.
But we live in a global world tied together by international trade. We are all in this together.
i am totally ignorant about finance in china, but do know something about the post-communist transition in eastern europe.
a big problem there was that at the time of their breakup and privatisation, the legacy monobanks (bureaucratic entities that allocated notional credit in accordance with central planning) inherited enormous exposures to redundant communist-era industry. this meant that they were often captured by their biggest borrowers, leading them to lend more and more to redundant industries in a vain attempt to keep them afloat.
in some countries the problem even persisted after banking crises in the early-mid 90s led to recapitalisation of the banks by central government. the banks just went back to lending to the same borrowers as before for the same reason as before, i.e. because these borrowers were insolvent, but the banks didn’t want the bad debts to crystalise.
i wonder whether there may be similar processes at work in china. where you have large redundant companies or industries, lenders that have overextended themselves resulting in large concentrated bad debts, rampant corruption and weak market discipline, you can end up with banks continuing to throw good money after bad.
hmmm. actually, maybe this problem is not so unique to communist countries..?
Dr Pettis,
If the central thrust of what you say is true – that it will be difficult to nearly impossible to adequately increase Chinese domestic consumption to keep production at current and growing levels, then the Chinese government has a real problem on it’s hands. If unemployment continues to grow, and it is difficult to see how this is unavoidable without dramatic changes being made to the current system, then warnings of ‘social unrest’ are likely more dire than being described in the media.
Assuming the Chinese government wants to keep their jobs (and their necks), they will come to the realization that their survival depends on renewed consumption, foreign or domestic. If the barrier to renewed western consumption is it’s debt, then China faces one of three options.
One option is to continue on the road we’re on: Accept the fact that dramatically reduced exports to the west, resulting in dramatically increased unemployment, vastly increased social unrest, and social instability may threaten the Chinese government itself.
Option two, forgive me for repeating the points I made on your previous posting, China can precipitate a conflict with the west, resulting in vastly increase military (domestic) spending, like the US did in WW2. Conflict & resulting nationalism would create the political backing to spend truly staggering amounts of money which will keep the people employed and the current leaders safe. But I don’t think leadership will not see this as an acceptable option – they understand that nationalism can be very hard to contain once the genie is out of the bottle.
Or there is a third, if unintuitive option. Start fresh with those whom China is co-dependent on. Forgive western debt and allow the west to borrow still more. This is not a bankruptcy I am suggesting. It is debt forgiveness. Maybe I am channeling Tom Friedman a little too much lately, but as much as I dislike what he says, I have to agree with it. When cautious, conservative home buyers & tax payers like myself are asked to bail out speculators and those who took out spectacularly stupid loans, it may not be fair, but it IS in my interest to bail these folks out because the consequences of allowing them to get their just deserts is simply unacceptable.
So, I won’t belabor the point again. But I think it behooves us all to think outside the box for new solutions to these serious problems. I understand that what I’m suggesting is outside many comfort-zones, politically, economically, and in terms of justice. But the path of forgiving western debt is one that returns the world, if unfairly, to the status-quo. It keeps the Chinese economy productive and growing. It avoids conflict with the west. And it gives time for real, sustainable solutions to be devised that adequately address this upside-down world that we live in.
The problem of banks being captured by industrial firms was something that the government was very worried about in the 1990′s, and it was much of the reason why China structured its banking and industrial systems along American lines rather than Japanese, German, or Korean systems. I don’t think that it is a huge problem that this point. One reason for this is that if the commercial banks don’t want to lend to someone that the government wants to keep in business, they can be shifted to the policy banks.
Dave G: Accept the fact that dramatically reduced exports to the west, resulting in dramatically increased unemployment, vastly increased social unrest, and social instability may threaten the Chinese government itself.
I don’t think so. There are lots of options that the government can go through, and those options aren’t particularly painful. The easy one is massive stimulus spending.
Also it takes a long time for a ship to sink. The Soviet Union started to economically stagnant in the early-1970′s but it took twenty years for things to fall apart. If the Chinese government goes through several years of economic stagnation or one year of extremely bad conditions then the government may be at risk, but it’s not going to fall next month or even next year.
One other thing is that exports to the West really haven’t gone down that much. One interesting fact is that Walmart hasn’t reported a downturn in earnings.
Credit Suisse had a note out today:
China’s experience during the last downturn indicates that private investment (using industrial investment as a proxy) will
mainly follow the direction of business sales rather than funding costs. For example, China started cutting interest rates in
May 1996, but industrial investment growth bottomed only in end-1999, while industrial investment growth basically moves in
tandem with industrial sales growth.
MXQ, that is probably right. To the extent that cutting rates will have any effect on borrowers, it is likley to increase production, but it probably won’t have much effect. Borrowers don’t want to borrow to build.
Twofish.
The Union of the soviets dosen’t had any many connection with the remaining part of the world,so they was able to made a slow decline,without external accelerators.
But china deeply integrated,and dependent, so if the external issues could cut that 20 years to two year.
Don’t forget,the russian czar was droped out from the power within half year in the last big economical downturn.
In the US, changing short term interest rates immediately changes economic activity because it hits the repo and commercial paper markets, and changes the borrowing activity in the short term debt markets. In China, most large corporations are financed through retained earnings so short term interest rates don’t change that much.
There are two effects that cause things in China to be reverses as far as interest rates go. The first is that if you fix borrowing rates but move lending rates, then you end up with more lending. The second is that if you increase rates then it becomes profitable to lend to riskier clients and then this increases lending volume.
I don’t think that interest rates are going to cause huge changes in household behavior.
Also I think that people are mixing the impact of the credit crisis with the impact of PBC tightening that occurred earlier this year. Export volumes haven’t gone down thus far, they probably will in the following months, but they haven’t gone down yet. However the PBC started tightening loans late last year, and the result of that is starting to sink in.
The Chinese government doesn’t have infinite time, but things will have to get a lot worse before it’s under threat. One thing that is helping it is that no one has come up with an economic or political alternative. Even if you think that the current government is incompetent there aren’t any alternative policies or ideologies out there the really offer any reasonable expectation a better economy. This is very different than in 1989.
My apologies if this is so obvious as to go without saying, but isn’t it possible, given the structure of Chinese production, that lowering the cost of capital results in the substitution of capital goods for labour?
If I can finance a backhoe cheaply, wouldn’t I dispense with some of the people on shovels?