China rates going lower as tide of capital heads out

James Saft Reuters columnist The tide of capital is going out in China and many boats, in Chinese ports or not, will settle lower in the water in consequence. 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 US$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 grey-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. 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 on-going need for refinancing, and is finding that debt is less and less effective at stimulating growth. China’s total debt roughly quadrupled to US$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. Reuters