China’s central bank surprised most observers last month when it announced its first interest rate cut in more than two years. The move is intended to bolster growth in the world’s second-largest economy, following stimulus measures by central banks in Europe and Japan.
The People’s Bank of China cut its one-year lending rate by 0.4 percentage point to 5.6%, reducing the cost for businesses to hire and invest. It also lowered its deposit rate by a quarter point to 2.75%, while giving banks a more liberal hand in how to pass that on to consumers.
But the PBOC emphasized that the cut was neither a change in China’s monetary policy nor a move geared towards boosting the economy – which is growing at the slowest pace in more than five years. Most China watchers, however, interpreted this to mean exactly the opposite. They saw it as a moment of awakening for China’s leaders to the need to show their commitment to preventing the economy from slowing any further.
The economy was in desperate need for more liquidity to avoid slipping into deflation. Growth in both consumer and producer prices has been slowing for much of the year. And the leadership felt it had to do this even if it meant offsetting efforts to fight spiraling debt loads among local governments and the growth of a shadow banking industry that operates beyond the reach of regulators. Both groups will get a boost from a lower interest rate.
Investment and consumption: a balancing act
But will the stimulus work or is it the wrong medicine for what ails the Chinese economy? And does it signal any change in how China’s leaders oversee monetary policy? To answer these questions, we have to go back to a fundamental issue of how China manages demand for its goods and services.
First, China’s growth has long been driven by investment rather than consumption, in contrast to most Western economies. Since 2010, private domestic consumption has accounted for only about 35% of China’s GDP, significantly lower than 60% in Japan and 70% in the US. In other words, China produces a lot more than what its own market can consume, which is why it has been so dependent on exports and foreign demand to absorb this surplus.
Second, when the world economy falters, this imbalance between investment and consumption gives rise to a serious problem of excess capacity. In other words, China may have produced more computers, jeans and other goods than consumers at home and abroad are willing to buy. This was exactly what happened during the financial crisis five years ago when global demand dried up, prompting China to shore up domestic consumption by implementing a 4-trillion-yuan stimulus program – about US$650 billion in today’s dollars.
Too much stimulation
But it didn’t really work. While it might have added a few percentage points to GDP growth, it actually worsened the overcapacity issue it was trying to remedy by overstimulating the manufacturing sector. Much of the liquidity injected into the market was disproportionately distributed to state-owned enterprises and investment companies created and endorsed by local governments.
This newly injected credit allowed the state sector to maintain or even expand its capacity, even as market demand remained subdued. Since the state sector is concentrated predominantly in capital-intensive industries, this has led to excess capacity accumulating mainly in industries such as cement, coal, petrochemicals and steel.
In light of what happened during the crisis, is the recent rate cut going to do much good? This mostly depends on whether local politicians are allowed to distort how the additional bank credit gets allocated, as was the case in 2008 and 2009. From this perspective, China’s banking system remains pretty much the same as it was then. The cut will not only give the deeply indebted state-owned enterprises and investment companies a new lease on life, but it will also leave the overcapacity issue unresolved, or even worse than before.
China’s Marshall plan
Global investors reacted to the rate cut with great enthusiasm, especially in commodity markets. But it’s a different plan that they should be paying more attention to, one that could actually solve China’s overcapacity problem and have a more measurable impact on the world economy, if not an entirely favorable one.
Two weeks before the cut was announced, Chinese President Xi Jinping proposed a new initiative for regional economic integration labeled “One Belt, One Road.” Dubbed China’s Marshall plan, this grand project would establish a so-called Silk Road Fund with US$40 billion to invest in infrastructure within certain countries in Central and Southeast Asia. This plan offers a better solution to the overcapacity problem than cutting interest rates as it promises to develop a large external market for Chinese products.
Piecing together these two policies gives us a clear picture of how China’s economic governance might affect the global economy. Given the absence of more fundamental reforms in China’s political economy, the issue of misallocation of resources and overcapacity in China will still linger. But, at the same time, the country is about to take advantage of its growing influence in the region to solve its domestic economic issues.
The stimulus should help some parts of the world that will benefit from any increase in Chinese growth, but it will also mean more competition for others as the country throws more of its increasing economic weight around. Especially within the neighboring regions where China holds more sway, countries competing with China in the sectors plagued by overcapacity such as petrochemicals and steel will face strong pressure to restructure.
In regions where China enjoys less of a presence, by contrast, more trade conflicts between China and her partners in these markets will loom large.