Last night the PBoC surprised the market with its biggest rate cut since 1997. Lending rates for one year or more were cut by 108 bps, while the six month lending rate was cut by 99 bps. Deposit rates were also cut, but with smaller cuts in short term rates (36 bps for demand deposits) and bigger cuts for long term rates (126 bps for five year deposits). The market was expecting the rate cut, but did not expect it to be so big.
One of my students asked me yesterday what I thought the stock market reaction would be. I gave him what by now has become a fairly standard response from me. The market will surge tomorrow, I told him, but within a few days it will give it all back. For the record on Wednesday the market rose 0.4% (perfectly retracing Tuesday’s decline).
In fact I underestimated the speed of the market’s response. It did surge this morning, racing up 6.6% in the first fifteen minutes of trading, but then spent the rest of the day drifting down, to close the day at 1917.9, up 1.0% for the day.
I am not sure why the market gave up the gains so quickly, but I suspect that at least part of it may have been recognition that the big cut reflects government fears about the pace of the slowdown. If the government is so worried, investors tell themselves, perhaps they should be too. In that light, an article in today’s Bloomberg discussed an NDRC warning today:
China’s economy is deteriorating more quickly as the impact of the global financial crisis spreads, underscoring the need for “forceful” measures to support growth, the nation’s top planner said today.
“Some economic indicators weakened further in November, showing a faster decline,” Zhang Ping, chairman of the National Development and Reform Commission, told a briefing in Beijing. “In order to curb an excessive economic slowdown, we must adopt forceful measures that have a noticeable impact.”
The dramatic rate cut was, presumably, one of the “forceful measures”. As for the “noticeable impact”, for a long time I have assumed without thinking about it too much that cutting rates was generally expansionary, and so was either a good thing in an economic contraction or, at worst, neutral. This certainly seems to be the case in the US. I have been thinking a little more about the impact of the rates cut, however, and wonder if it really is the same in China. The structure of the Chinese economy and banking system is very different, and so it might not necessarily be the case that a rate cut will do what the government hopes.
A large interest rate cut of this nature creates losers and winners. Savers of course are losers, because they will earn less on their savings. The macro question, I think, is how lower returns on savings will affect domestic household consumption. On the one hand one can argue that it reduces the incentive to save, and so may encourage households to step up their consumption. In that case the rate cut would be good because it helps boost domestic demand.
But there is another view. I think my friend Dan Rosen, a professor at Columbia University, made this point a year or so ago in a different context, but he argued that reducing the return to savings may actually cause households to increase their savings since it will take them longer to achieve whatever long-term savings objective they have. If I earn less on my savings, in other words, I need to save more (and consume less) today to ensure that when I retire I have whatever I think I will need to ensure a comfortable retirement. The fact that savers in China for many years have earned negative real rates of interest may be one reason that consumption is low in China. The erosion of the real value of existing savings means that households have to save more just to stay even.
In the end this is not a theoretical argument but a purely empirical one. The impact a rate cut will have on household savings is whatever it turns out to be, but for now we can’t predict with much certainty its impact on boosting consumption. If any of my blog readers know of useful studies on the subject, I would appreciate a citation or link.
The winners in this rate cut, of course, are borrowers. Their cost of funding has just declined substantially. Here, however, I am afraid that the effect of the rate cut on Chinese economic problems might be different than expected.
The first and most obvious point is that this rate cut will provide breathing space to over-indebted borrowers, of whom I suspect real estate developer are a large part. This may slow down the tendency to liquidate real estate, which is clearly good for the market in the short-term, but it also slows down the adjustment – and perhaps allows overbuilding to continue a little longer. This is good if the crisis is a short term one, but bad if it drags on for at least another couple of years (which I think it will).
Of course it is not just real estate developers who are affected. In the US, a rate cut usually boosts both production, by lowering the cost of capital for businesses looking to create capacity, and consumption, by making it easier for consumers to finance purchases, especially large purchases (homes, automobiles, etc). In that sense rate cuts are likely to be expansionary because they increase demand.
Here in China, however, the consumer loan market is so small that I suspect the impact on consumption will be much smaller – perhaps it may encourage some home buyers, but not much more. Most lending in China goes to the productive sector – businesses. In that case it would be easy to argue that interest rate cuts are more likely to boost production than consumption.
At first that would seem not to be a problem. In the US, for example, anything that boosts the likelihood of businesses to borrow and build factories is unquestionably good for the economy. As they produce more, they employ more workers, which boosts demand. They sell the additional production mainly to the larger US consumer base, who can obtain cheaper consumer financing, and who still consume more than they produce (i.e. the US runs a trade deficit).
But is this the case in China? I have argued that, viewed from the global balance of payments model, China and the US suffer from opposite problems. The US has consumed far more than it produces and China has produced far more than it consumes. The decline in US household consumption means that China (and perhaps the US government) needs to boost demand, or else they will see a contraction in production that entails firing workers and closing factories.
Because bank lending in China is far more oriented towards production than towards consumption, I am not sure that an interest rate cut in China will have the same demand impact that it does in the US. More worryingly, it might have a disproportionately large impact on boosting supply of manufactured goods. In a sense, lowering interest rates can be seen as subsiding borrowers, except that in China most borrowers are producers, not consumers.
Do we really want to subsidize more production? I need to think about this more, but my instinct tells me that lowering interest rates in China may actually exacerbate the global imbalance between production and consumption.
A better policy action than lowering interest rates may be something that was hinted at in an article in today’s People’s Daily:
China’s economic planning agency said on Wednesday the country may raise the income of residents to create more favorable conditions for people to spend more. The government would improve the consumption environment and work on people’s anticipation of future spending, an unidentified official of the National Development and Reform Commission (NDRC) said in a statement posted on its website.
However, the official did not give further details on these measures. “To carry out policies that stimulate domestic demand is a very important footing of the country to weather through the global financial turmoil,” he said.
He continued to argue that such policies to bolster domestic demand should persist for a long time, as the policies play an important role in spurring the economy right now and will also boost market confidence and increase the momentum of the economy in the long run.
Ok, this does not seem very substantial, but the fact that it was posted – however anonymously – on the NDRC website and displayed prominently in both Xinhua and the People’s Daily may suggest that this is not some minor afterthought, and that perhaps there is more to come. It is consumption, not production, that everyone’s efforts should be aimed at boosting.