China’s Latest Interest Rate Cut: The Essential Context

By John Richardson

CHINA lowered interest rates for the third time in six months on Sunday in a further attempt to limit the damage caused by economic reforms.

The two earlier rate cuts, and February’s reduction in the bank reserve-requirement ratio, were also about limiting the pain resulting from the boldest, most risky set of economic reforms for at least the last 20 years. China hopes that cheaper and more  plentiful borrowing  will help minimise the number of corporate failures.

This remains the absolutely essential context in which you must judge all the monetary easing measures taken by China to date, along with any further steps in the same direction.

You must not, and simply cannot afford to, any longer indulge in the wishful thinking that rate cuts etc. signal a return to the heady days of double-digit GDP growth.

Here are five reminders of why this has to be the basis for your analysis of China:

1. China’s total debts rose from $7 trillion in 2007 to $28 trillion by mid-2014, said McKinsey in a February 2015 report. Debt service charges cost China 17% of its 2014 GDP, according to a January study by Fitch. Chinese debtors paid interest costs close the size of India’s GDP last year ($1.87 trillion) and costs larger than South Korea’s ($1.3tn), Mexico’s ($1.26 trillion) and Indonesia’s GDP ($870 trillion), said the Financial Times last October. And last week, the People’s Bank of China, in its latest monetary report, said: “Rising debt is forcing China to use a lot of resources in repaying and rolling over debt”.  So this obviously means that greater liquidity resulting from this latest rate cut will almost entirely end up servicing existing debt.
2. Even if these debt-servicing costs were not so alarmingly high, it would simply be crazy for China to encourage more investment in oversupplied industries such as steel, aluminium, some petrochemicals and real estate. This is the type of investment, though, that is the only swift route back to double-digit growth. Instead, the focus has to be on restructuring oversupplied sectors. The lower cost of borrowing should make the mergers and acquisition process a little less painful.
3. It would be equally crazy for China’s government to return to the old investment-led growth model for environmental reasons. A headlong rush into the wrong kind of investment has already led to chronically polluted air, soil and water, and so today’s focus is instead on closing down, rather adding to, the type of factories that have wrecked China’s environment.
4. China has reached the “Lewis Turning Point”. This means that it no longer has the surplus migrant labour to support any further investment low cost manufacturing in coastal, developed provinces of China. Increasing urbanisation is still viewed as a huge positive for China’s economic growth. But just 20% of the workforce is now employed an agriculture, according to Cai Fang, vice-president of the Chinese Academy of Social Sciences, which advises the government. This compares with an official estimate of 48%.
5. China’s government is not crazy, but is instead determined to press ahead with essential, and very difficult and painful, economic reforms. President Xi Jinping and Prime Minister Li Keqiang need to accelerate this process right now so they can show positive results by 2017. That year will mark their fifth year in office, and so is the date set for a mid-term official review of their progress.

Every government has, however, “red lines” which cannot be crossed – and the biggest red line for China remains employment. It has to keep enough of its blue collar workers in jobs whilst also generating enough new types of employment for its vast army of graduates; hence, trying to limit corporate failures through reducing interest rates.

Pressure on jobs is rising, according to CNBC:

Last month, the Liaoning province government said it slashed its annual job creation target to 400,000 from 700,000, to reflect a “severe” employment trend. Separately, the Labour Ministry warned that authorities should not be “blindly optimistic” as the pace of job creation is slowing.

I have long argued that China will thus seek to export some of its vast manufacturing surpluses in order to protect jobs. This will result in China exporting deflation to the rest of the world.

The latest data supports my argument. For example, Reuters wrote in this article:

Exports of steel products jumped 33% to 34.31 million tonnes in the first four months of the year from the same period in 2014, while those for aluminium products leapt almost 40% to 1.65 million tonnes over the same period.

Overall, the trend is likely to be that Chinese steel and aluminium producers will be encouraged to keep output high, and may try to boost exports as a way to sell surplus output.

High operating rates may also boost imports of raw material such as iron ore and bauxite, but given the emphasis on preserving jobs, it’s also likely that domestic mining, particularly of iron ore, will be encouraged, even if it’s loss-making.

And what about oversupplied sectors of the petrochemicals industry – for instance, polyvinyl chloride? (See my chart at the beginning of this post)

Here are some factors to consider here:

• Restructuring in this sector is likely to only involve the closure of 60,000-100,000 tonnes/year inland plants – in other words, poorly located small-scale facilities. Even if a large number of these plants were shut down, this would not be enough to bring the local market back into balance.
• Meanwhile, we could see larger plants closer to the coast run harder in order to boost exports and so protect employment.  This could be made easier both by the lower cost of borrowing and other government incentives. For example, PVC exporters already receive a 13% VAT rebate. What if this rebate was raised to the maximum 17%?