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 China, somewhat unexpectedly, cut monetary policy yet again over the
weekend, the third time in recent months it has moved to ease
conditions.
This makes reasonable sense given China's rapidly slowing growth and
the concurrent movement of capital out of China. Still, it looks as
if the yuan, on a slow-moving peg against the dollar, may be headed
lower in value.
That's stimulative for China but will spread the pain, in the form
of weak demand and very low inflation, elsewhere. To be fair, China
is far from alone in playing this game, what with the ECB embarking
on quantitative easing and Japan in the midst of a currency
depreciation and asset-buying plan that can only be called heroic,
if not necessarily wise.
China trimmed its key interest rate by 25 basis points to 5.35
percent, at the same time adjusting down a saving rate and lifting
slightly a cap on deposit rates. This follows closely a February
reduction in the amount of reserves banks must hold, a move taken
because a November rate cut had not sufficiently filtered through to
lending.
China faces a series of interrelated challenges. It is trying to
loosen its tight controls over its financial system while managing a
very rapid slowing of its economy, to a nearly quarter-century slow
rate of 7.4 percent last year. As a result, money, which once flowed
hot into China, now wants out. China's capital and financial account
had a deficit of more than $90 billion in the fourth quarter, the
largest such in at least 16 years. Exporters prefer, suddenly, to
keep foreign currency earnings in foreign currency and overseas
investors see less opportunity in China.
All of these forces are self-reinforcing, just as they were in the
opposite direction for most of the past 25 years.
Given that it is in service to creating a more consumption-oriented,
less manufacturing-dependent economy, this is acceptable to Chinese
authorities, but not without costs, there and elsewhere.
ONLY AS GOOD AS YOUR BANKING SYSTEM
Because the inbound tide of capital lubricated the economy, actually
often bypassing the banking system into gray-market loans, its
reverse means China will have to continue to loosen policy to soften
the downturn.
Veteran economist George Magnus points out that real rates in China
have drifted higher, due in large part to low and falling inflation.
Also having an effect is the very effective restrictions Chinese
authorities have placed on the shadow lending markets. This has
driven more would-be borrowers to traditional banks, allowing those
banks to be both choosier about whom they lend to and to demand more
by way of an interest rate on loans they do make. The weighted
average bank lending rate is now approaching 9 percent in
inflation-adjusted terms, according to UBS estimates, up from below
7 percent in 2014 and as compared to less than 1 percent in 2011.
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One issue too is that the shadow lending market existed for a set of
reasons which haven't gone away as it withered. Traditional Chinese
banks aren't always that keen to lend to small and medium-sized
businesses, sometimes preferring lending to the kind of politically
connected state-owned enterprises which are notable more for size
than efficiency and dynamism.
That means that the interest rate cuts that the PBOC is pushing
through are having a bit of trouble reaching the real economy, if
such a term can be used for China.
In the meantime, China has both a tremendous amount of debt, which
implies a huge ongoing need for refinancing, and is finding that
debt is less and less effective at stimulating growth.
China's total debt roughly quadrupled to $28 trillion between 2007
and the middle of last year and is now larger, in comparison to its
economy, than that of the U.S., according to McKinsey & Company.
Since the financial crisis the incremental return, in economic
growth, from additional debt has actually turned negative, according
to calculations by hedge fund SLJ Macro Partners. In other words,
more debt is now detracting from growth rather than hastening it,
almost certainly because the quality of projects which the debt
funds has become so poor in China, particularly in real estate.
The temptation will be to allow its currency to fall to spread the
pain a bit and ease the transition. That means a disinflationary
impulse sent into an already disinflationary world.
Think of it as currency collateral damage.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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