By John Richardson
LATE last year China’s government launched one final round of old-style economic stimulus so they could build-up political support ahead of the boldest set of reforms to the economy in at least 20 years.
This was clearly, therefore, a tactical decision, as I argued at the time.
But a lot of other commentators interpreted the stimulus programme as evidence that the “Chinese economic miracle” would, somehow, continue.
They ignored the rising challenges of bad debt, unproductive investments and the environmental crisis.
And they equally ignored the language of China’s new leaders who made it absolutely clear that painful, very difficult reforms were on the way.
To put it bluntly, their interpretation of events was just plain wrong.
And so I had a feeling of déjà vu on Friday when far too many analysts were delighted by the surprise announcement that China had cut interest rates for the first time in two years.
They interpreted this as a major policy reversal. Far too many people talked about a re-stoking of the world’s“economic growth engine and of how the interest rate cut, which might well be followed by another rate cut, was all about boosting flagging GDP growth.
This is once again the wrong interpretation, but it doesn’t necessarily mean that the analysts making these comments “don’t get it”. Some of them do get it, but their job is to talk-up financial markets so investors can make short-term gains.
This kind of analysis is obviously of no value whatsoever to a chemicals company that has to plan for the long term.
So, what does the rate cut really mean?
Here is my four-point guide, based on some excellent commentary from the right kind of analysts:
- Beijing wants to push ahead with further painful reforms next year, including tackling the mountain of bad debts faced by local governments, and so the last thing they need at this stage is local authorities defaulting on their borrowing. Hence, rates have been cut to take the pressure off regional governments.
- The People’s Bank of China (PBOC), which, of course, announced the rate cut, has given us another reason for the decision: Reducing financing costs to help struggling corporations. The PBOC added that the rate cut did not represent an end to “prudent monetary policy”. It hammered the point home even further when it also stressed that there was no need for aggressive stimulus.
- At the same time as the rate cut was announced, banks were given the freedom to set deposit rates at 20% above benchmark borrowing costs. Previously, they were only allowed to set deposit rates at 10% above the cost of borrowing. Although this might not have an immediate big effect on deposit rates, this is an important step towards liberalisation of the financial sector. “Financial repression” in China has involved low savings rates. Low savings rates have enabled the banks to funnel lots of cheap loans to companies – mainly big, well-connected state-owned companies. Due diligence has often been very bad on these loans, which is a major factor behind today’s bad-debt crisis. In the future, though, the greater flexibility given to banks in setting deposit rates will force them to compete for customers by offering higher rates. This will, hopefully, also force them to charge higher borrowing rates and make them more discerning about who they lend money to.
- The rate cut might also be a step towards a devaluation of the Yuan, which I discussed as a possibility earlier this month. “The rate cut, along with prolonged weakness in the Japanese Yen, will increase political pressure on the PBOC to allow a modest devaluation in the currency, both to reflect a normal market response to rate cuts and also to shore up export competitiveness in the face of downward pressure on Asian currencies across the board,” said the Eurasia Group.
The next task is to try and figure out what the interest rate cut will mean for China’s small and medium-sized enterprises (SMEs). These companies are vital to chemicals and polymers demand as they buy the bulk of chemicals and polymers in China.
A reduction in interest rates in China does not necessarily lead to a surge in credit; bank lending volumes are controlled by quotas and there was no indication on Friday that these have been relaxed.
“Unless these limits (lending quotas for individual banks and, for smaller banks, loan-to-deposit ratios too) are relaxed, today’s rate cuts won’t lead to any increase in the volume of loans supplied,” said Mark Williams, chief Asia economist at Capital Economics.
“As such, the impact on GDP growth will be small. The main effect will be to improve the financial position of large firms,” he added.
The rate cut did, however, appear to mesh with a ten-point plan announced last week by Li Keqiang, China’s prime minister. The plan includes more credit support for small enterprises.
But the mood has changed in China – and I think that the mood has been deliberately changed. The government has sent a clear message to everyone, which is: More painful reforms are on the way and so don’t take excessive risks.
Lending to SMEs by the mainstream banks might therefore still be seen as too risky compared with the safety of dispensing credit to the big and often state-owned companies. The bigger the company and the closer its links to the government the less likely it is to fail, is a common and realistic view.
This will leave SMEs heavily dependent on financing from the shadow-banking system, where interest rates can be 30% or even higher.