China’s economy: thinking beyond the short run

What’s the true picture of Chinese economic stimulus? China’s decision to cut interest rates actually has modest implications for Australia. AAP

Last week’s decision by China to cut interest rates by 0.25% seemed to attract almost as much attention in Australia as the same decision by the Reserve Bank of Australia (RBA) several days earlier.

The regulated benchmark lending and deposit rates in China now stand at 6.31% and 3.25%, respectively.

So enthusiastic have we become in Australia to economic developments in China that last week a fiscal stimulus package was also being declared in our major news outlets prior to it even being announced by the Chinese government.

For their part, the Chinese government denied any large scale stimulus was on the cards.

Such instances reflect the conviction of many in Australia’s macroeconomic commentariat that our economic fortunes are now driven almost exclusively by China.

In actual fact, China’s interest rate decision is of little consequence to the Australian economy for reasons quite apart from its modest scale.

As I have previously noted on The Conversation, the channels through which developments in China can spill over to impact on Australia’s economy are not nearly as extensive as many would believe.

For example, recently released Australian Bureau of Statistics data show that Chinese investment in Australia fell again in 2011, as it also did in 2010. Last year’s net inflow of less than $A1 billion was the lowest value recorded since 2005.

The fact that the Chinese share of the stock of foreign investment in Australia remains at less than 1% is extraordinary given that China now absorbs nearly 30% of our merchandise exports and has been one of the world’s leading net capital exporters over the past decade.

More importantly though, the reason the interest rate cut is of little consequence to Australia is that it is of little consequence to China itself.

Many commentators observed that China’s rate cut was the first since 2008. There is a simple explanation for this – the level of interest rates in China have no significant bearing on investment decisions and hence aggregate demand.

To understand why, institutional differences between China’s financial system and Australia’s need to be appreciated. In China, the major borrowers are large and medium-sized state-owned enterprises. Their investment decisions are far more sensitive to the directives of government officials and the availability of credit, not its price. Meanwhile, entities with hard budget constraints, such as households and privately-owned firms, largely fund their spending through savings and informal credit channels.

The impact of interest rate adjustments in China is also weakened by the fact that financial markets are incomplete. For example, consumer credit and corporate bond markets are only in their infancy. This means that adjustments in benchmark interest rates in China do not have the same wide-reaching impact that adjustments in the cash rate have in Australia.

There was however one development last week with respect to interest rates in China that was genuinely newsworthy. Alongside the rate cut, the authorities there announced that banks would be given flexibility to offer to savers up to 110% of the benchmark deposit rate (that is, as high as 3.58%).

This means that, at least in principle, Chinese banks are now better able to compete for savings based on price.

One of the more serious structural distortions in the Chinese economy has been regulated deposit and lending rates that see a large transfer of wealth from households to state-owned banks and enterprises. This has frustrated the much-needed change for growth to be driven more by domestic consumption rather than investment and exports.

Increased interest rate flexibility has the potential to reduce this distortion.

To be sure, the extent to which competition amongst China’s banks can be relied upon to act upon interest rate flexibility is questionable. Much like Australia’s banking system, China’s is also dominated by just four big banks, and in their case, all are majority government-owned.

Nonetheless, the focus on the rate cut instead of the increase in flexibility - with some honourable exceptions - highlights an important shortcoming in Australia’s macroeconomic commentary.

Ultimately, the impact that China has on Australia will be determined by the extent to which it can address its structural deficiencies, not its cyclical downturns. That is, whether China’s short run growth slows markedly is of far less importance than its average rate of growth over the longer term.

In truth, economists also have a poor record of forecasting short run changes in variables such as GDP. In the academic literature, there is an influential school of thought that argues GDP behaves as a “random walk”.

This implies that the best forecast of next quarter’s GDP is current GDP plus some random error.

Short run forecasts in the case of China are particularly fraught given concerns over data quality. A colleague in the private sector recently told me that he refuses to participate in forecasting surveys of Chinese macroeconomic data. In his words, “The average forecast of 20 people who have little clue is basically noise”.

All the more reason then to focus on developments in China that have longer-term implications.