The Peoples Bank of China (PBOC) yesterday announced a cut of 25bp in China’s one-year lending rate, bringing it down to 4.6%. The move, which came into effect today, was accompanied by an equivalent cut in the savings rate and a lowering of the reserve requirement ratio.
This decision was widely interpreted to be a response to fears of economic slowdown after a string of disappointing economic data sent the Shanghai index tumbling by around 22% from peak-to-trough over the past few days. Today’s expansionary move builds on Chinese policymakers’ attempts earlier this month to stimulate the market through (a) a currency devaluation and (b) a decision to authorise pension funds to invest 30% of their assets in equities. After an initial positive response to yesterday’s news, global markets lapsed back to free-fall when they opened this morning.
The string of events we’ve seen in China and global markets over the past few weeks can best be described as a negative spiral, whereby moves to stimulate the economy are received by markets as a signal of policymakers’ worries about China’s economic health, something that in turn sends the stock market plunging further. This short-term game however distracts attention away from China’s real problems. The root of the problem lies with China’s incredible levels of debt, particularly that concentrated in the hands of local governments. Local government debt alone stands at about 50% of GDP according to the latest study by the Chinese Academy of Social Sciences. This started to look unsustainable when China’s property market began to slow down earlier this year, bearing in mind that land sales constitute one of the most important sources of financing for China’s local governments. In response, policymakers attempted to ease the burden of debt by forcing banks to accept a ‘municipal bond swap plan’, whereby short-term, high-interest local government loans were turned into long-term, low-interest bonds. This of course put pressure on China’s banks, making them more risk averse and less willing to lend. The latest rate cut is unlikely to be a major catalyst in changing this attitude. Worse than just ineffective, the rate cut actually risks being a stumbling block for China’s long-term interests, by failing to give market forces a great say through prolonging reliance on debt and ‘easy credit’ to prevent business insolvencies.
Looking ahead, we believe that the magnitude of the decline seen in global stock markets is an exaggerated response to China’s short-term economic state. Those looking out for China to crash any minute now are overestimating the importance of the stock market in China’s real economy and underestimating the extent of ammunition power its policymakers still hold. In contrast, the risks for China’s long-term trajectory have increased considerably and a Japan-like two-decade long stagnation with a heavy debt overhang has now entered the realm of the possible.
Danae Kyriakopoulou
Senior Economist
(This is an excerpt from Cebr’s The Prospect Service)