Reform drives China’s policies

Pessimists are coming out in droves when it comes to China, broadcasting that all policy measures out from the middle kingdom are reactive attempts to boosting near term economic growth. 

China Flag
Source: Bloomberg

After three remarkable decades, pessimists proclaimed that China is about to crash. But these edicts are nothing new. Fears of a China hard landing have been making the rounds for quite a few years now. To be sure, that will be a disaster. China is the second largest economy in the world, and an important trade partners with many economies.

Recent economic data continued to reveal that growth is relentlessly slowing. China’s industrial profits plunged -8.8% y/y in September, accentuating shrinking manufacturing activity in the country. GDP growth in the third quarter expanded at the slowest pace since the global financial crisis, dipping below 7% for the first time since 2009.

This added to concerns about the Chinese economic outlook and clouded China’s prospects for achieving the official target growth figure of 7% for this year. Hence the drumbeat for more pro-growth measures grew louder.

Last Friday, the People’s Bank of China (PBOC) made a combination policy move, opting to reduce both the benchmark interest rates and the reserve requirement ratio by 25 and 50 basis points respectively.

The one-year lending and deposit rates now stands at 4.35% and 1.50% while the required reserve ratio for major banks dropped to 17.5%. After Friday’s moves, China authorities have cut interest rates six times in less than a year since November 2014, and reduced four times the amount of reserves that banks need to hold.


Reforms or to lift near term growth?

Against the slowing growth backdrop, it was not hard to judge the latest policy action as one aiming at cushioning growth. But are we missing something?

Drawing a straight line connecting slowing growth and policy actions may be too simplistic. Whilst simplicity is beautiful, making simple but inaccurate assessments may spell ruinous for investments.

China is putting itself through the paces of a massive restructuring exercise. The government is focusing on three vital areas, in which finance comprises one area. The other two areas are fiscal and administrative. They have started to relax control over interest rates as well as cross-border capital flows. Cheap credit has helped to fuel China’s double-digit growth for much of the past couple of decades.

This also led to problems of over-investment and over-capacity, which are plaguing the economy now. Moreover, the artificially low credit costs had depressed the returns for savers and aiding capital investments, especially from inefficient state-owned enterprises (SOEs).

To allow market forces to determine the equilibrium rates, a complete abolishment of caps on rates is necessary. That was what the PBOC did last Friday. The ceilings on deposit rates were removed, which would improve the returns available to household savers. This step is consistent with China’s aim to transit to a consumption-based economy.

More pointedly, the presence of deposit rates’ ceiling is increasingly made redundant by the proliferation of bank-account substitutes which capture nearly one-third of household savings, according to an Economist article. Put differently, the caps on deposit rates are no longer as effective to keep rates low as previously, given more alternatives for households.

The policymakers realised this and are taking incremental steps to opening up the financial sector. Zhou Xiaochuan, the governor of the PBOC, has commented that there is a strong possibility that a full rate-liberalisation will materialise by the end of this year.

The moves ahead of the IMF review on yuan’s inclusion in the Special Drawing Rights (SDR) also appeared to be well-timed. Beijing has implemented a range of reforms to open up its markets and to help the yuan meet the SDR criterion of being ‘freely usable’. Reuters reported that the IMF is leaning towards an approval for yuan to be included in the SDR basket.

Viewing from the ‘financial reform’ lens, the latest rate cuts should be seen as part of a controlled easing cycle, as part of broader restructuring efforts. Certainly, the measures would also provide a fillip to near term economic growth. However, the key message is about reforms, not so much of meeting growth targets.

The Wall Street Journal noted that that Premier Li Keqiang has emphasised that the 7% GDP benchmark is an approximate, and not a target to be defended at all costs. He added that ‘the Chinese economy should operate within a reasonable range’.

The RRR cut can also be perceived as playing a smaller role in China’s push for financial reforms. While mandatory banks’ reserves are typically not a key policy tool of developed economies, they formed an essential toolkit in China to maintain yuan stability. During the rush to invest in China, the central bank needed to absorb the huge amount of foreign currencies into the domestic financial system by exchanging them with the yuan.

Normally, the massive influx of domestic currency into the financial system should stoke inflationary pressure, but the PBOC cleverly dampen such effects by forcing the banks to lock up a significant chunk as reserves. The RRR reached a peak of 21.5% in June 2011. This suggests that there is still room for more RRR cuts, while policy space for more reduction in the interest rates may be limited.


Easy monies bankrolling equities

Monetary policy easing is almost always interpreted by investors as a signal to buy shares. The explanation goes like this - With more liquidity being released into the banking system, lenders may increase loans to companies, which would expand their operations. Ultimately, this should transmit into more economic activity, and higher profits.

Indeed, we are seeing not just Chinese equities, but global equities are also being bid on prospects of more easy-money conditions globally. Mario Draghi, president of the European Central Bank (ECB), talked up hopes of a step-up in its bond-buying programme last week, explicitly making references that it would consider more policy easing in the December meeting.

This should be a cautionary tale for investors. The global central banks are driving the risk markets, not economic growth or companies’ earnings strength. 


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