China – Has monetary policy shifted?

The People’s Bank of China (PBC, the central bank) surprisingly cut benchmark interests rates on November 21st. This has generated speculation that further monetary policy easing will follow, as the authorities seek to ward off deflationary pressures and stimulate economic growth. However, The Economist Intelligence Unit views the cut as more an adjustment of the PBC’s policy stance, which remains focused on deleveraging and financial-sector reform, rather than a fundamental realignment. As such, the impact of the move on economic growth is likely to be minimal. 

The PBC’s decision to lower its benchmark one-year deposit and lending rates to 2.75% (from 3%) and 5.6% (from 6%) respectively took the markets by surprise. The bank had previously signalled its reluctance to engage in large-scale monetary policy easing. Instead, the authorities’ focus had been on bringing under control levels of leverage in the economy. Growth in credit has been on a downward trend since early 2013, although it is still running at a rate well above that of nominal GDP expansion. There was still some way to go before China even approached deleveraging.

Chart showing change in nominal GDP and renminbi loans since 2008

At first glance, then, the PBC’s decision suggests a loss of willpower. When interest rates were lowered in 2009 and 2012 they prompted a boom in credit issuance. In theory, the same could result again, threatening the agenda that the PBC has set out for itself. There have been growing calls from within policy circles for the government to support economic activity more aggressively, amid weakening economic growth and growing deflationary pressures. Although the PBC has more independence over monetary policy than in the past, it is still beholden to the stability-focused leadership of the ruling Chinese Communist Party.

An adjustment, not a shift

We think that the rate cut is a nod to such concerns, but does not represent a fundamental break with the agenda that the monetary authorities have given themselves. It appears mainly designed to prevent the slowing pace of consumer price increases (and the acceleration of the decline in factory gate prices) from causing an unintended tightening of monetary policy. Disinflation has pushed up the real cost of borrowing for firms, many of which (especially in the state-owned sector) are laden with substantial debt. Liquidity injections into the financial system by the PBC in September and October failed to transmit into lower borrowing costs, so the authorities may have decided a bolder and more transparent move was required. Nevertheless, lowering interest rates to ensure that real borrowing costs remain constant does not represent a major loosening measure. The PBC itself described the move as a “neutral” operation in an accompanying statement.

The PBC has also been careful to make clear that its reform agenda remains intact. Besides lowering interest rates, the central bank chose to announce that it was raising the ceiling against which banks are allowed to set deposits rates to up to 20% above the benchmark rate, compared with 10% previously. Many lenders have already taken advantage of this relaxation. This step towards freeing up deposit rates—restrictions on lending rates were removed in 2013—provided an important signal that financial sector reform remains a priority. Plans for a deposit insurance scheme have since been announced, representing another important step towards full interest rate liberalisation.

Cautious on more easing

Efforts to signal policy continuity suggest that market expectations for more monetary policy easing may be wide of the mark. In the past, interest-rate cuts have typically arrived in sequence, rather than as one-off measures. However, the PBC has cautioned against such suppositions on this occasion. In its statement, it said that it believed economic growth was still within a “reasonable range”, implying that it sees little need for assertive pro-growth measures. Besides its comfort with the economy’s performance, it seems unlikely that the institution would want to risk jettison the deleveraging agenda on which it has staked its credibility and which it sees as fundamental to long-term economic sustainability. Tackling overcapacity in the industrial and real estate sectors, one of the main sources of current disinflation, will require a tight stance on credit issuance.

Of course, there could be developments that might prompt the PBC to revisit its stance. If deflationary pressures mount further, the central bank might take further steps to ease financing costs by lowering interest rates. A sharp slump in economic activity would also prompt a reassessment. However, our core assumption is that the PBC will seek to maintain an appropriate balance between growth and reform, rather than compromise the latter by opening the credit floodgates altogether.

Growth still set to slow

Given the broad continuity anticipated in monetary policy settings, we see no need to make significant revisions to our core economic growth forecasts. In the past, lowering interest rates worked to lift GDP growth, with credit flowing to real-estate investment in particular. There could be some short-term lift in construction activity again on this occasion. Already, developers have ramped up purchases of land in first-tier markets.

However, the impact of the interest rate cut is likely to be modest compared with those in the past. In real terms, firms are unlikely to feel much of a difference in liquidity conditions, which is likely to encourage caution over investment. The outlook for the property market is also not bright. Over-supply in many cities means developers and buyers are less bullish than before. Banks will also be wary about extending credit to the sector given their already high exposure to it and broader concerns about managing rapidly rising non-performing loans.

With credit unlikely to surge into the property market, we remain comfortable with our forecast for real GDP expansion of 7% in 2015. This assumes that investment growth will moderate, although the drop in the expansion rate will be more modest than it was this year. China’s transition to a different economic growth model was never going to be easy, and the interest-rate cut highlights the difficulties that the authorities will experience as they seek to balance reform with stability. However, there is little reason to suppose that they have abandoned their reform goals altogether.