Local governments took the opportunity to shed their fiscal burdens. Without a slow-down, another 15 per cent could close by end-1998. This would trigger a serious fall in industrial output and employment, and raise the likelihood of social instability at a time when government reforms are meeting strong resistance. Hence, the credit policy easing may be as much a political as a macroeconomic necessity for the government.
Towards floating rates
Economists question the effectiveness of the interest rate mechanism in fine-tuning a state-planned economy like in China. Interest rates can be a useful tool in an economy where industrial development is largely a function of commercial decision-making. However, it does not apply in China, a country with a relatively low dependence on international trade and capital markets, despite all the reforms over the past 20 years. Exports account for only 20 per cent of GDP and the foreign debt/GDP ratio is a mere 14.5 per cent, as against regional averages of 51 per cent and 35 per cent respectively. This shows the degree to which the Chinese economy remains closed, and the extent to which corporates borrow funds domestically and sell to local consumers. Consequently, internal credit policy is relatively unimportant to over-all industrial growth and competitiveness.
Last year's experience proved this, when the government's use of monetary expansionas a means to kick-start the economy failed to deliver the goods. Thus, in a clear policy shift this year, Beijing is using fiscal stimulus along with credit easing to boost domes-tic demand, says Biliang Hu, Socgen-Crosby's China economist. New export tax rebates, recently extended to several export-intensive industries such as shipping, machinery and high-technology product categories, are just one example.
"The VAT rate for small commercial firms has also been cut from six per cent to four per cent," adds Hu. "And the government plans to issue more treasury bills and expand investment in railways and highway construction to Yn4.5bn (US$542m) and Yn 160bn (US$19.28bn) respectively this year. These co-ordinated policy measures aim to boost growth in the second half of 1998."
The latest rate cuts are a stepping stone towards floating the country's domestic interest rates and using them as a means to fine-tune the economy. The PBoC has already made public its desire to deregulate the interest rate regime and instead let them be determined by market forces. Over the past two years it has abolished the use of fixed, inflation-proof interest rates on long term time-deposits and treasury bonds, and adjusted the inflation subsidies to keep the long-term time deposits competitive.
Muted overall impact
Now, the central bank is attempting to rationalise the interest rate structure. "The commercial lending market has remained tightly controlled and the 112 base point cut provides more leeway in this direction. The final pillar, deposit interest rates, should take much longer to deregulate, so as to avoid excessive competition for customer deposits among banks," says Pan Ming, head of China's latest interest rate salvo, attempting to revitalise an economy standing on the brink of recession, is likely to have limited impact. On July 1, the People's Bank of China (PBoC) announced a cut in average lending rates and deposit rates by 1.12 per cent and 0.49 per cent respectively, its fifth such move since May 1996. Also, the central bank reserve requirement was reduced from 13 per cent to eight per cent and interest rates on reserve deposits cut to 3.51 per cent from 5.22 per cent.
Given weak domestic demand, falling investment growth and a worsening regional crisis that is thwarting the government's eight per cent growth target for this year, the economy is in need of a stimulus. Can lower interest rates help to deliver the solution?
The short answer is `no', in the opinion of many economists. `China needs massive credit reflation to break deflation's back and avert an economic recession,' commented the independent monthly forecasting newsletter BCA China Analyst. `We think the rate cut is too small, however, and may be too late to prevent further economic casualties.'
A political necessity
These rate cuts are part of a concerted govemment action to stimulate economic growth. Other measures include an easing of fiscal policy and housing reforms. Specifically, lower interest rates are designed to improve corporate profitability and boost retail consumption, infrastructure investment and exports. But they also show that the stakes are getting higher for Premier Zhu Rongji, who has pinned his reputation on an eight per cent GDP growth, currency stability and reform of state-owned enterprises (SOEs).
Says Dong Tao, senior regional economist at Credit Suisse First Boston: "When Premier Zhu Rongji announced his ambitious plans to overhaul the SOEs within three years, he thought everything was covered: inflation had disappeared and the growth was reasonable. But the pace of SUE closure has been much faster than expected."
An estimated 10-15 per cent of them were shut down in the first half of 1998 alone, as China Research at Prudential-Bache Inter-national.
These interest rate cuts appear belated ?given slowing retail sales and money supply, easing demand for bank credit from the non-financial sector and weakening exports. Industrial output grew just 7.9 per cent and fixed-asset investment rose 12.7 per cent in the first five month of 1998, as against the 10 per cent and 15 per cent figures respectively thought necessary to achieve the eight per cent growth target. And GDP expanded just seven per cent in the first half of the year, reflecting the plunge in domestic demand.
Unfortunately, the consumer sector's lack of sensitivity to interest rates makes it a blunt instrument in stoking domestic demand. "In the US, an interest rate cut stimulates demand for consumer durables and housing, which rely heavily on debt financing," explains Mr Andy Xie, economist at Morgan Stanley Dean Witter. "Increased consumption, then, pushes up the level of economic activities. China, in sharp contrast, has no significant consumer financing business for purchases of durables."
However, the cut in the lending rate isnow deeper and for a longer period ?five-year loans and above are now 2.34 percent-age points cheaper. This is in line with the government's aim to boost the economy through stimulating infrastructure investment. Foreign direct investment in the main-land plunged in May, reaching US$3.17bn, after growing steadily in the first quarter. With the mainland's chief investors in the region ?Japan, Taiwan and Hong Kong ?being caught in the regional crisis, this trend is expected to accelerate. And many remain sceptical about the effectiveness of rate cuts in reversing the investment trend.
Banks will bear the pain
The returns on investment in China have fallen sharply since 1993 and are now much below the cost of capital, according to Xie. Even after the latest lending rate cut, the returns on equity remain poor and below capital cost. This will keep domestic companies from channelling funds into infra-structure projects. Equally important, the real interest rates (net of inflation) at around nine per cent, still remain higher than in September 1997 .in China, thus leaving no more incentive for corporates to invest more now than in 1997. Also, lossmaking SOEs are unlikely to view a marginal cut in credit costs as an inducement to invest more. Many state enterprises would prefer to use whatever funds they can garner for working capital, paying salaries or simply striving to stay afloat. Government-sponsored infra-structure projects in areas like construction, telecoms, energy and power, however, will benefit from reduced cost of funds.
The rate cuts are primarily aimed at relieving the debt burden of the ailing SOEs, which carry a debt-equity ratio of more than 160 per cent. The financial performance of these monoliths, especially among commodity or export-oriented industries, has worsened alarmingly following the Asian crisis. A PBoC survey puts the combined losses of the top 5,000 industrial enterprises in China at Yn5.7bn (US$687m) for the first two months of this year. And losses are expected to mount as the deflationary trend works its way through in the national economy.
"The rate cuts will improve the cashflows of the SOEs, which will save Yn45bn (US$5.7bn) in interest repayments alone this
China's average rate reduction history (per cent)
May 1996 August 1996 October 1997 March 1998 July 1998
Lending rates 0.75 I.2 1.5 0.60 1.12
Deposit rates 0.98 1 . 5 1 . 1 0.16 0.49
Source: MN Amro HG Asia year," says Guonan Ma, regional economist at Salomon Smith Barney. Capital-intensive industries, such as steel and textiles, will also gain from the rate cuts.
Commercial lending is likely to get a boost, thanks more to aggressive cuts in reserve interest rates and PBoC's refinancing loans, than because of actual lending rates. "This widening of interest rate differentials will rectify PBoC's earlier monetary policy slippage, which focused only on cutting commercial lending rates to stimulate loan growth," says Wong. This practice encouraged banks to park cheap deposits at PBoC, thus creating a liquidity trap. While making the banks cash-rich, it kept surplus funds from circulating through the system. Ma predicts loan growth to surge 15-17 per cent by end-1998, up from the current 12 per cent level, following the recent rate cuts and a 17 l base point cut in reserve requirement.
Impact on savings levels
But it is doubtful. whether the freed-up funds will find their way into the hands of more deserving' borrowers. Beijing recently instructed banks to lend more to struggling SOEs, in a short-term reversal from its previous stance. The preservation of the state sector is vital for achieving the eight per cent growth target in China and maintaining social stability. The closure of state enter-prises is having a major impact on the income of individuals and their consumption levels. These industries, while declining in importance at the macroeconomic level, still account for a substantial proportion of industrial production.
Hence, the government is attempting a soft landing for the SOEs and moderating its corporate reform process. This will invariably add pressure on a banking sector that was learning to say `no' to risky lending. Asharp rise in banks' bad loan ratios and receivables looks inevitable.
Moreover, the banks' net interest spreads are set to contract further following a smaller cut in deposit rates than in the lending rate. While the central bank's aggressive slashing of the refinancing lending rates partially compensates for this, overall bank profitability is going to be hurt. Meanwhile, falling deposit rates will likely turn the Chinese towards potentially more attractive investment options such as equities and bonds to park their combined Yn5,000bn-worth of domestic savings. A recent launch of mutual funds, which was seeking to collect Yn4bn, garnered Yn200bn in subscription, says Dong, showing a clear hunger for fresh opportunities to channel private money.
To date there has been no sign of bank savings levels being denuded, although this may be due to a time lag. A survey of Beijing residents published in China Business Information Network indicated a possible shift in savings patterns after the recent cuts in banking interest rates. Some 45 per cent of respondents said they would spend their money on their children's education, houses, home appliances, cars and marriage, compared with 27 per cent who would continue to deposit in banks.
Housing reforms to accelerate
Economists say that lower interest rates, combined with the recent mortgage rate cuts, are an essential measure to spur individual home purchases and strengthen the government's housing reforms. The mass residential housing sector is one of the few growth engines capable of countering slowing consumption and exports, and jump-starting the Chinese economy. Its significance is not lost on the government, which is counting on the repeated rate cuts to stimu-
late private house buying. Hu expects lower interest rates to accelerate housing sales by 30 per cent in 1998, as against the single-digit growth recorded last year.
Not everyone is so optimistic. Mr Chu Siu Wah, DBS Securities' China economist, says that limited availability of mortgage lending in China may dampen the positive impact. "Mortgage financing is still in its infancy in China, with lending restricted largely to government and SOE employees," he says. "Hence, even a rate cut would not stimulate much public interest in residential units buying."
However, investments in real estate, which grew 15 per cent between January and May 1998, will accelerate further on the back of cheaper credit availability. Developers like the NorthStar Group and Huayan Group are among the biggest borrowers from banks, and stand to benefit most.
Little room for manoeuvre
There is little room for further interest rate manoeuvring in China this year. "The differences between yuan and US dollar deposit rates are inching towards negative. Further widening this gap could be destabilising for the exchange rate policy," says Xie.
Moreover, any further squeeze on the banks' thin margins could result in negative cashflows for them. "The net interest margin for banks is quite low at 200-250 base points due to the high level of non-performing loans, which constitute 25 per cent of loan portfolio," says Mr Eddie Wong, regional economist at ABN-Amro HG Asia. "And banks carry high operating costs. If the non-performing loan problem is not addressed quickly, this rate cut will be the last of the series."
Overall, the pattern of rate cuts shows Beijing's dilemma of trying to operate a monetary policy in the absence of a market-driven exchange rate policy. Aggressive interest rate cuts in deflationary times cannot help stir the economy without an adjustment in the exchange rate, which has been ruled out by the government. Sums up Xie: "China's monetary policy seems to have been reduced to squeezing the banks' margins."
New interest rate structure (per cent)
Holding companies can now establish group sales companies in Shanghai, writes Peter Corne of law firm Simmons & Simmons.
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