Why Cutting Interest Rates Won't Help China

(Bloomberg Opinion) -- The Chinese economy is sputtering, deflation looms and businesses are downbeat. Trade tensions with the U.S. portend an even scarier growth outlook. The Federal Reserve, too, has given China more room to ease. 

So where are the outright rate cuts?

Beijing has pulled out many other weapons from its vast arsenal.  Most recently it introduced a new tool that extends cheaper loans to big banks, which can only be used to lend to small and private enterprises. The People’s Bank of China has repeatedly lowered the amount of reserves commercial banks are required to hold and has injected gobs of liquidity into the financial system.  

Yet the intended effects still aren’t reaching the real economy. The headline numbers aren’t budging.  In most other parts of the world, the groundwork would be laid for an interest-rate cut.  

For China’s economy to respond to such a step, it needs rates that are market-dependent, whose impact flows throughout the interbank and wider financial system. Unfortunately, that’s still years away. The challenges officials face in transmitting monetary policy effectively persist. 

The past two decades have been filled with talk of China liberalizing its interest rates and creating a so-called corridor for the movement of a policy rate. Yet its financial system still effectively runs on two tracks. Banks’ deposit rates are largely controlled while money and bond rates are market-based.

Even those market rates are ultimately driven by controlled rates. For example, lending rates are determined by the market, but banks still rely on the PBOC’s published benchmarks to price loans. And because banks are big bond buyers, that market becomes closely managed, too.

Why Cutting Interest Rates Won't Help China

China has a long history of depending on banks to drive the economy. Its latest campaign to purge the country’s financial underbelly of debt (which fed credit to large swathes of the real economy) only made Beijing more reliant on this sector: Some 70 percent of the financial system is still funded by banks. As a result, China has two main operational rates: banks’ deposit rates and the seven-day repurchase rate, which determines their cost of funding from the central bank. 

Despite easing efforts, most bank loans were extended at or above benchmark lending rates until recently. Banks remained reluctant to take on risk, further evidence that rate cuts aren’t flowing through to the broader system. 

Why Cutting Interest Rates Won't Help China

Cutting official interest rates becomes a tricky move, then – chipping away at the profitability of the very institutions Beijing needs most. Yet lowering deposit rates to widen net interest margins isn’t an option either: One-year rates are already at 1.5 percent. And if China is really serious about moving toward a market-driven system, using the lending and deposit rates to manage an economic outcome is counterproductive. 

Deposit rates may even need to be higher to compete with other financial products and lure more savers. Theoretically, their cash would boost lending through the formal banking system rather than shadow channels. For the private companies and small enterprises that need these funds, cutting the benchmark lending rates, which affect mostly existing mortgages and state-owned enterprises, wouldn’t really move the needle.

Why Cutting Interest Rates Won't Help China

If Beijing wants banks to lend to struggling private-sector enterprises, and small and medium companies, they need to be compensated for the higher risk. For this to happen, their funding costs (or effectively, money-market rates) need to fall.

One option, according to Logan Wright from Rhodium Group, is a cut to the open market operation rate, which determines the price of money. That would improve credit transmission and reduce overall interest burdens for companies, he says. The flip side is that such operations still come at a marginal cost to the banks and, arguably, won’t flow to all companies equally. Another plausible approach is cutting rates on the central bank’s main lending facilities.

Besides the practical difficulties, it would be remiss to ignore the broader policy consequences of rate cuts including pressure on the currency, spurring capital outflows, and inflating the property market.

Beijing’s hands are tied. These multiple challenges mean interest-rate liberalization will sit on the back burner for a while, despite recent chatter from the central bank  around reform. No doubt, China is primed for more easing actions. But waiting for an interest rate cut that would weaken a pillar of China’s financial system is likely a fool’s game.

It's also armed with short-term liquidity operations and a host of other lending facilities, many which aren’t based on market rates. It targets short-term rates through the quantity of open market operations.

The PBOC has mentioned the standing lending facility rate of 3.5 percent as an upper limit and the rate of excess reserves as a lower limit. It hasn't been clear about labeling a policy rate, but investors and analysts often refer to the seven-day repo rate.

China's deposit-rate ceiling was removed in 2015. However there are still implicit limits imposed by various regulatory bodies. Meanwhile, the lending-rate floor was removed in 2013 (except formortgages).

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

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