November 20, 2014    5 minute read

The Chinese Growth Dilemma: Stimulus or Reform?

   November 20, 2014    5 minute read

The Chinese Growth Dilemma: Stimulus or Reform?

The Chinese economy, which has been growing at rates of as much as 10% in the third quarter of 2011, has fallen to a 7.3% growth rate in the third quarter this year, the weakest in the past five years. This has set the economy to miss its growth target of 7.5% this year. Alongside this, investment growth is at a 13-year low, fixed-asset investment growth is at its lowest since 2001, and factory output is growing at its second lowest rate since 2009. There are fears that the weakening in growth will be exacerbated.

Monetary Stimulation

A careful look at the situation reveals that a monetary stimulus is justifiable. China currently pegs its currency, the renminbi (RMB), against the U.S. Dollar in which it can only rise or fall by a maximum of 2% per day from a fixed rate set by the People‘s Bank of China. Despite the renminbi falling by 1% so far this year, the USD has recently hit a four-year high. Besides this, the Yen and Euro have fallen by 7% and 14% against the U.S. Dollar respectively since the beginning of the year. As a result, the Chinese currency is currently at a record high against the Yen and the strongest against the Euro in over a decade. This makes it much more difficult for China to compete in the global economy as a strong currency has an adverse effect on a country‘s ability to export goods. A monetary stimulus would devalue the currency and potentially allow exports to increase, thereby contributing to economic growth.

Annual inflation was near a five-year low in October at 1.6%. ANZ Economists said in a research note that “the risk of deflation has risen as the economy is expected to further slow further in the next few quarters.” By taking a look at Japan, we can see that the potential consequences of deflation could be devastating. Further evidence show that the producer price index fell 3.2% from a year ago as low demand reduced the pricing power of companies and that many Chinese companies are facing increased borrowing costs as banks become more reluctant to lend due to the slowing economy and rising defaults.

The Issue At Hand

The main problem is that the People’s Bank of China (PBoC) is very reluctant to use traditional monetary policies such as cuts in the required reserve ratio and interest rates to stimulate economic growth. Despite refusing to cut the Required Reserve Ratio (RRR) and interest rates, the PBoC injected approximately RMB770bn into the banking system through their Medium-Term Lending Facility (MLF); a new monetary policy tool. This is typically more than what would be injected into the economy through a 0.5% point cut in the RRR. However, Economists argue that a cut in the RRR is needed, partly because its effects are permanent unless the PBoC reverses the act. In comparison, the MLF provides three-month loans to commercial banks only. With growth still declining, it is evident that current stimulus is not sufficient.

During a meeting in September, top government officials agreed to focus on reforms in the economy over stimulus and accept any failures to meet their economic growth targets in the short run. They have pledged to stick to difficult reforms and fear that any cut in the RRR or interest rate could be read as signs of backpedalling on their word. Furthermore, in July this year, President Xi spoke about the ‘new normal,‘ that China should adapt to slower and more sustainable growth. As a result, China has started to focus on structural reforms over stimulating the economy.

Given the above, it is unlikely that the PBoC will resort to cutting interest rates or the RRR in the coming few months to try and stimulate the economy. However, the door to broad-based RRR remains open. It is clear that there are political factors which are affecting the PBoC‘s ability to manipulate interest rates and the RRR. Although China is still the world‘s fastest growing economy, there are still risks that could arise in the short-to-medium run in the form of deflation and reduced international competitiveness.

November 21, 2014 Update:

In contrast to market expectations, the PBoC unexpectedly cut interest rates today to try and stimulate the Chinese economy. This shows that after months of indirect easing strategies to try and counter the slowdown, Beijing has opted to use a more forceful approach to boost the economy. The PBoC cut its one-year lending rate to 5.6 percent and the one-year deposit rate by 0.25 percent to 2.75 percent. It also raised the cap on the deposit rate to 1.2 times the benchmark, up from 1.1 times. However, Economists are skeptical about this move as they believe that it’s unlikely that there would be any boost to lending and growth. The rates cut boosted global stock markets with the S&P 500 index opening up 0.9 percent and the Stoxx Europe 600 Index rallying 1.6 percent in afternoon trading.

The reduction in benchmark lending rates is likely to benefit firms, usually large or state-owned firms, which borrow from banks. However, the rates cut is unlikely to affect smaller banks who borrow from the shadow banking sector. The lower rates are unlikely to cause banks to switch away from the safety of state borrowers who are guaranteed by the government. In addition, the cut itself is neutral because the lower lending rate and the increased ceiling on the deposit rate cancel each other out. The PBoC has acknowledged this and hence, in that sense, the rate cut is not as effective as it should be.

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