Friday, June 8, 2012

Worsening Economy Forces China’s Interest Rate Cuts

Worsening Economy Forces China’s Interest Rate Cuts
Cuts give banks greater flexibility in offering loans

By Tianlun Jian

Fears of a hard landing appear to have caused the People’s Bank of China (PBOC) to have reached into its tool kit to find another way to spur China’s sluggish economy. Along the way PBOC may have taken a step toward reform of China’s banking system.

PBOC had previously relied on cutting bank’s reserve requirement ratio to stimulate the economy. This time it has tried cutting interest rates.

Only 20 days after twice cutting the reserve requirement ratio this year, the PBOC lowered the benchmark lending and deposit rates by 25 basis points to 6.31 percent and 3.25 per cent, respectively, on June 8.

Furthermore, the PBOC changed the lending and deposit rate bands. Banks are now allowed to pay as much as 10 per cent more than the benchmark rate on deposit, the first time a premium was allowed. Also banks can now offer a discount of 20 percent from the benchmark lending rate, wider than the previous 10 percent.

In effect, financial institutions may pay potentially as much as 3.575 percent on deposit and charge 5.048 percent on loans, leaving a net interest margin of 1.5 percentage points, much lower than before (3 ppts).

As one would expect, stocks of Chinese banks dropped sharply on June 8, the first day of the rate cut. ICBC dropped 4.91 percent to HK$4.26, its lowest since Nov. 30, in Hong Kong, while the city's Hang Seng Index declined 0.9 percent. Similarly, China Construction Bank Corp. fell 4 percent to close at HK$5.28.

A Forced Move

Domestic economic growth is decelerating. The debt crisis is worsening in Europe, China’s largest trading partner, threatening China’s export growth and the entire economy as well.

Recent Chinese economic data indicate that the economy has slowed significantly.  The first quarter GDP growth of 8.1 percent was the lowest since Q2, 2009 and much lower than the 10.4 percent and 9.2 percent in 2011 and 2010, respectively.

April economic indicators are all much lower than those 12 months ago. Investment and exports, the driving engines for China’s high growth in the last decades had growth rates half that of April 2011.

Urban fixed asset investment grew only 19 percent year-over-year in April vs. 37 percent in April 2011. Foreign direct investment had a negative growth vs. a 15 percent growth 12 months ago. Exports growth slowed to merely 4.9 percent from 29.9 percent in April 2011. Please see the chart below for detail.

Growth Rates
Total Retail Sales of Consumer Goods
Industrial Output
Urban Fixed Asset Investment
Foreign Direct Investment
Exports (Customs data)

The HSBC PMI, which tracks China's small and medium sized firms, fell to 48.4 in May from 49.3 in April.  That was the seventh straight month-on-month decline in overall new business. 
Meanwhile, new bank loans dropped 32.5 percent in April from March.

It is under such an economic environment that the PBOC was forced to cut the interest rates in hope of boosting China’s credit market and avoid a hard landing. 

The Potential Effects

This time the rate cut is significantly different from the past. The PBOC not only changed the tool, it also increased the flexibility for banks in setting the interest rates. By allowing a 20 percent discount on the benchmark lending rate, in effect, the PBOC lets banks lower the lending rate as much as to 5.05 percent. 

That is, compared with the previous lower band of 5.90 percent  (=6.51%*90%), the lending rate is down 85 basis points, instead of 25 basis points.  This is quite a significant cut, more than three times what it appears to be!

Its intention, I believe, is to lower the cost of capital for investors and borrowers, and perhaps, to allow banks to charge borrowers of different risks with different rates. If that is the case, who will benefit? The state-owned enterprises and government agencies. They have been the major clients of Chinese banks and regarded as low risk clients.

The rate cut will indeed relieve those high-debt SOEs, local governments and government agencies. However, this will not help much for the economy as a whole.

Small and medium-sized enterprises hire about 80 per cent of China’s workforce, need capital to grow but are often shut off from bank loans and capital markets. Very often they have to borrow through the black market with rates as high as 30 or even 50 percent.

Compared with the 6.51 per cent benchmark lending rate before the rate cut, they are paying a lot higher. In other words, to these enterprises, the level of interest rates, high or low, does not matter as much as the quantity of loans that they can get.

The biased credit control stops businesses from accessing the credit market. If loans are still extended to favor government-linked companies, as has been the practice for the past decades, China’s credit market will not improve, and neither will the economy.

In the past few years, the housing bubble has developed into a serious issue for the economy. The Chinese government has taken some measures trying to contain it, including administrative measures and raising interest rates and the bank reserve requirement ratio.

Now the rate cut would surely relax the money supply and potentially spur inflation. By cutting the rates, apparently, the government is now worried more about a hard landing than the housing bubble.

However, if lowering rates results in more money flowing into the real estate market, and further inflating the housing bubble, then, the rate cut will only be counter-productive. And the economy will be structurally even more unbalanced.

From another perspective, the changes in the lending and deposit rate bands will accelerate bank competition in China and squeeze net interest margins. This policy shift may be taken as a step towards bank reform, away from the monopoly banking system.

With more flexibility in setting interest rates, banks may evaluate and measure risks of different clients and projects, and charge differentiated interest rates. At the same time banks can, through paying higher interest rates, attract more deposits.