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China Cuts Rates for the Third Time, What Do the Tea Leaves Say?
   2015-05-19 15:09:51    CRIENGLISH.com      Web Editor: Xie Tingting

By Zhao Yang (About the author)

Over the weekend, China's central bank, the People's Bank of China (PBOC) cut benchmark lending and deposit rates by 25 basis points, reducing the one-year lending and deposit rates to 5.1 percent and 2.25 percent respectively. The PBOC also increased the interest banks could pay on deposits from 1.3 to 1.5 times the benchmark rate. There is also speculation that the PBOC may consider credit easing tools which would allow local governments to restructure debts.

The third rate cut by the PBOC since November makes this the fifth time in six months that it has either cut rates or lowered bank reserve ratios. This has sparked speculation, domestically and internationally, that China, facing continued downward pressure in its trade, manufacturing and real estate sectors, will pursue western style fiscal and monetary mechanisms and easing.

This means most people are betting on further rate cuts and interventions; but is this a good bet?

While it is possible that the PBOC may continue to reduce lending rates and internal bank reserve ratios and introduce new government debt restructuring mechanisms, it would be a mistake to focus on this as China's main economic response to its economic challenges.

The main reason China won't be relying on purely fiscal and monetary tools, is that recent history has shown that the efficiency of these moves decreases every time they are used. This is a lesson the US Federal Reserve learned, and other central banks around the world are learning, the hard way. Sending rates into negative numbers and engaging in new rounds of quantitative easing has produced less economic impact every time they have been used, thereby requiring even more exaggerated responses.

In China's case, analysts are discussing whether China will continue to use monetary and fiscal policy as its main tools, especially in view of the "other tools" at its disposal.

What are these "other tools"?

The government's control of the State Owned Enterprises (SOEs) gives it the ability to control and reform major parts of China's strategic industries. The government is able to plan, fund and implement domestic and international social and economic programs, quickly, and as necessary. For example, the AIIB, One Belt One Road, Silk Road Fund, and BRICS Bank are all initiatives based on funding and implementing a massive infrastructure program. This gives China a significant advantage to restructuring its economy.

To understand what will probably happen next, here are some of the issues and trends one should be looking at:

Six months of declining producer prices signals significant deleveraging, but cannot continue for much longer before it starts seriously impacting the economic viability of the companies and workers involved.

Steady but weak inflation of 1.5 percent in April, which came in below expectations but was still above that of March's 1.4 percent and January's 0.8 percent.

Weak exports: Exports fell 6.1 percent year-on-year in April, adding to March's 15 percent decline following an approximate 50 percent increase in February; but in real numbers China's exports continue to rise. Analysts had expected a 1.6 percent gain in April. Most of the downturn was attributed to weak demand from the EU which fell by more than 10 percent while exports to the US expanded at about 3.5 percent.

April imports also fell for the sixth month in a row, down 16.2 percent year-on-year, weaker than the expected 10.5 percent decline.

April's trade surplus was just over 340 billion US dollars, which is likely to result in more pressure from trade partners when combined with falling imports.

There are also worries about company and local government debt loads, with the PBOC stating in its monetary-policy report that the "rising debt size is forcing China to use a lot of resources in repaying and rolling over debt" while limiting the room for further fiscal expansion. This can only be solved through either direct support, allowing the market to force efficiency, or a hybrid which stretches out loan maturities and amortizations.

There has also been a rise in bad loans evidenced by the fact that the China Banking Regulatory Commission reported that non-performing loans surged 140 billion yuan (22.6 billion US dollars) from the beginning of the year to 982.5 billion yuan as of March 31, the biggest quarterly jump in more than a decade.

Probable moves; the government's strategy for getting its economy going:

Continued bilateral and multilateral trade agreements and initiatives are likely to abound which will improve trade opportunities in all directions, with a prime example being the China, Japan, South Korea free trade talks.

We are also likely to see further implementation of the infrastructure initiatives and funding mechanisms involved in the One Belt One Road, AIIB, BRICS Bank, and Silk Road Fund. These initiatives will be China's most important economic driver in terms of creating multiple trade routes for resources coming to China and exports flowing out. They will develop new markets for Chinese goods and provide a more stable economic basis for participating countries and will also put China at the forefront of a new international development model. Chinese companies and workers are looking to supply much of the infrastructure improvements and if the AIIB and Silk Road Fund elect to use a modest amount of leverage they could easily become the world's leading finance mechanisms.

Furthermore, observers will no doubt see continued reform which likely means continued consolidation and transparency of SOEs in areas where the government feels there is a national strategic interest, like high speed rail, nuclear and energy sectors, accompanied by more rigorous governmental oversight of monopolies, in terms of market performance, safety and environmental impact.

The government is also likely to promote the creation of new and more reliable investment vehicles for long term investment of pension funds and insurance companies. Alongside this, government debt swap vehicles will allow governments to turn over debt at lower interest rates and longer maturities; a move which will be accompanied by more central government scrutiny of provincial and local government spending.

There will also be further rate liberalization, eventually leading to a removal of rate caps; though this will depend on the maturity of the banking sector which needs to position itself to serve the new micro, small and medium sized entities which the government is trying to encourage.

Of course, the process of RMB internationalization will continue, which will lessen transaction trade risk for Chinese exporters and importers and the government will also implement targeted stimulus plans in social service areas including hospitals, elderly care, schools and affordable housing.

There is also likely to be an expansion of free trade zones, the dismantling of tariffs and governmental red tape, direct encouragement of micro, small and medium sized enterprises and entrepreneurs, and innovation through policy, rule and educational emphasis changes. Though fiscal and monetary tools are probable weapons in the government's arsenal for tackling economic issues, the response is likely to be far broader.

This article is partly contributed by Einar Tagen.

About the Author

Zhao Yang hosts a China Radio International business flagship program Biz Today. Before that, she has been a financial reporter for CRI's London correspondent bureau. She was actively involved in reporting the financial market in the city of London, and the Chinese economy as well.

The opinions expressed here are only personal, and do not necessarily represent CRI's official policy.

Read all opinion stories by Zhao Yang



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